Have you ever continued with a project long after you should have let it go, only because nonrecoverable money and time have already been put into it? For example, consider an executive who persists with their decision to open a new division even when it fails to generate sufficient revenue, or a manager who keeps poor performers around just because they’ve spent thousands to train them.
This type of decision-making, in which businesses continue to pursue an endeavor just because they have invested (unrecoverable) resources in it in the past, illustrates the “sunk cost fallacy.” The phenomenon was first introduced by Nobel prize-winning economist Richard Thaler, who suggested when people must pay to use a good or service, the rate at which it will be used increases.
The sunk cost fallacy is a real danger for businesses because it motivates them to continue with projects they’ve invested time, effort and money into, regardless of whether the current costs outweigh the benefits. Even worse, sunk costs can have dire consequences for strategic decisions, clouding the judgment of business leaders due to their emotional attachment to the sunk costs.
Famous examples of the sunk cost fallacy
Remember the late 1990s decline of General Motors, once the symbol of American industrial might? GM’s plummeting market share was widely attributed to its decision to continue manufacturing large vehicles at a time when the market was trending toward more fuel-efficient and hybrid cars.
What about the once-Fortune 500 firm Eastman Kodak? The company was so invested in its film-based products that it ignored the photography industry’s digital revolution, ultimately leading to its bankruptcy.
So, what causes businesses to fall prey to the sunk cost fallacy and make irrational investment decisions that lead to poor outcomes? Here’s a quick guide to understanding sunk cost fallacy and how your business can avoid falling into its trap.
Understanding sunk cost fallacy
What are sunk costs? As the name implies, these are costs that are sunk, that is time and/or money has been spent. It’s a done deal and there is no reversing that — which is precisely the problem.
What is sunk cost fallacy? Ideally, sunk costs shouldn’t be considered when making investments or business decisions. However, time and again, emotions and information related to past decisions — the sunk costs — are taken into account when making future decisions. It goes something like this: “We spent X thousands of man hours to develop this new product. It hasn’t generated enough of a return to break even yet, so we will keep pushing the product in hopes of at least recovering our R&D cost.” Or, “We spent X dollars to open that outlet. We don’t want it to be a total loss, so we will keep pursuing it till we make that location successful.” This is the sunk cost fallacy.
In short, sunk cost fallacy is the pursuit of an inferior option (a money-losing endeavor) merely because significant, but unrecoverable, resources have been invested in it. This flies in the face of the rational decision-making process in businesses, but it happens all the time.
Why does it happen? Experimental evidence published in NCBI finds that the sunk-cost fallacy is driven by negative feelings caused by the prospect of having invested significantly in an endeavor without success. After having incurred sunk costs, people are willing to take the risk of further losses that continuing investing may bring.
Outlined below are five key reasons why sunk cost fallacy occurs.
Commitment bias. Businesses may stick to a plan, even when it is clear that this is no longer a viable choice, because that was originally decided upon. Once an investment in money, effort, or time has been made, they are committed to the plan and will keep trying to make it work, no matter what.
Waste avoidance. A study by Dr. Hal R. Arkes and Catherine Blumer find the sunk-cost fallacy is motivated by ‘not to waste’. People may want not to appear wasteful and hence persist with the decision even when it is clearly a failing plan.
Personal decision-making. It may so happen that those involved in the decision-making may feel emotionally attached to or responsible for a specific project or business decision. This creates an emotional bias that the idea may turn or the available data indicating failure may be incorrect, thereby making it difficult to give up on it.
Loss aversion. The sunk cost fallacy may in part occur due to loss aversion, which describes the fact that the impact of losses feels much worse to us than the impact of gains. People have a tendency to avoid a loss over an equivalent gain and owing to their low-risk tolerance they are unwilling to commit to a guaranteed loss — that is ending a project that has a sunk cost.
How does it impact businesses? While pursuing an inferior option, the focus is on how much time and effort has already been spent on it rather than how it’s working. This distracts businesses from making good decisions jeopardizing their success.
How to avoid falling into the sunk cost fallacy
So how can you keep from falling prey to the insidious thinking error? On the one hand, throwing good money over bad in the futile hope of justifying your resources expended can lead to bigger losses. On the other hand, there is no way to lead a business without taking risks.
The key is to not become so indifferent to your business losses that it leads to excessive risk, or become so concerned about past losses that the sunk cost fallacy becomes an albatross around your neck. The goal, then, is to make decisions based on the future utility or future payoff of the project or idea, not on your past feelings or previous investments.
Here are five ways to help you overcome the sunk cost fallacy in your business.
Look at the big picture. Start with a vision and make decisions based solely on that. Also, ensure to communicate your business vision in a detailed way to everyone in the company, and have it where it can be referenced often.
Embrace creative tension. While the dominant narrative in the business world is to get rid of tensions and discord because they’re seen as bad, embracing creative tension can be a good way to prevent the sunk cost fallacy in your business. It will help you clearly understand the gap between where your business is (current reality) and where you want to take it (vision and goals), and thereby come up with better solutions. Thus, helping your business become more resilient and thriving.
Get more seasoned decision-makers on board. A recent Harvard Business Review research suggests that being wise is likely to count more than being smart with regards to avoiding sunk cost fallacy. The research states, “experience or stocks of knowledge (so called “crystallized intelligence”), rather than raw computational power (“fluid intelligence”), enable one to avoid falling prey to the effect.”
To cut a long story short, wise leadership is the key to better decisions — they have a better understanding of when to pull the plug and refocus the resources being wasted in a failed endeavor.
Focus on the facts. In deciding if something is a lost cause or a worthwhile endeavor, ensure to consider only the data and facts. Exclude any opinions, emotions, or dreams of what might be. In short, focus on what is absolutely known and certain; not what could be.
Learn to accept and let go. Part of the sunk cost fallacy has to do with avoiding the embarrassment or shame of admitting that a decision was unwise. It is important to let go not just of the loss, but also shame. Accept and own your failure; and move on with important lessons in mind.
No matter what, don’t buy into the sunk cost fallacy. When things aren’t going according to your plan, dropping the pursuit of the inferior option (money-losing project) and aligning your response with the long-term business goals is crucial not only to your company’s success, but also to its survival.
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