“If we give up now, then everything we’ve done was for nothing.” A Business Owner Somewhere, Everyday
What if I told you that there’s an expense that many businesses suffer each year, that never leads to any return? This expense will not show up on any financial statement nor any tax return. It remains hidden from view, siphoning off valuable dollars from otherwise excellent businesses. How could this be? How could a cost hide from savvy business owners? We know our numbers; we know our KPIs.
It’s because this expense hides among the valuable, income-producing, expenditures we make. While this cost may not have a particular line item, it does have a name: the Sunk Cost Fallacy. And the only way to find it, and to beat it, is to know how to look for it.
What is a Sunk Cost?
A sunk cost is a cost that has already been incurred and cannot be recovered. By itself, a sunk cost is not destructive for a business. Any amount you’ve spent in your business may be one that cannot be recovered. The fees you paid your CPA or lawyer, the cost of ads you ran, the consultant you brought in to help streamline operations, all of these are sunk costs. Sunk costs alone are not what kills our bottom line. Sunk costs are bad for business because of the sunk cost fallacy.
The sunk cost fallacy is our tendency to continue investing time, money, or effort into a project simply because we’ve already invested resources into it, even when it’s clear that continuing is not the best course of action. In other words, it’s the mistaken belief that you can’t abandon a project because of what you’ve already put into it.
Sunk costs on their own aren’t bad, but their related fallacy can kill a business. The fallacy lies in factoring these irrecoverable, sunk costs into future decisions.
Why is it a Fallacy?
The sunk cost fallacy is a fallacy and irrational because sunk costs should not factor into decisions about the future. If a project or initiative is not delivering the expected results, pouring more resources into it will not change that. You are better, and more rationally, served to base decisions on expected future costs and benefits, not past expenditures.
Here are a few examples of the sunk cost fallacy at work. In each the money outlaid is already spent regardless of what you do next. It’s not coming back no matter what you do. The fallacy lies in thinking you need to continue with a doomed product or campaign, or a wrong fit hire, to make it worth it, or to try to recover these costs when all of your data says you won’t.
Think of it this way: if you wouldn’t embark on a project knowing what you know now, then continuing to invest in that project is irrational, regardless of how much you’ve already put into it.
Spotting the Sunk Cost Fallacy at Work
The sunk cost fallacy at work would be easy to spot if there was a particular label or line item that applied. But while there’s no easy label, once we know what to look for sunk cost fallacies are easy to spot. Let’s consider a few examples:
1. Product Development: Imagine your company has spent $500,000 developing a new product. However, market research indicates that demand for the product is low and it’s unlikely to be profitable. The sunk cost fallacy might tempt you to launch the product anyway, hoping to recoup your investment. However, the rational decision would be to cut your losses and redirect resources to more promising initiatives.
2. Marketing Campaigns: Perhaps you’ve invested $15,000 into a marketing campaign that’s failing to generate leads or sales. The sunk cost fallacy might encourage you to double down and invest even more, hoping things will turn around. But you’d be better served to acknowledge the campaign’s failure, learn from it, and try a new approach.
3. Hiring Decisions: What about a scenario where you’ve spent $50,000 in wages, time, and resources training a new hire who is underperforming? The sunk cost fallacy might make you reluctant to let them go, feeling you need to justify your investment. But holding onto a poor performer can be more costly in the long run than cutting ties and finding a replacement.
4. Consultants & Advisors: Finally, consider a trusted consultant. In the past, they’ve given great advice, but in recent times the advice is not so helpful, is late, or hasn’t evolved with the needs of your business as your business has evolved and scaled. The sunk cost fallacy might make you feel that you need to stay with this advisor because of what you did together in the past, particularly the time and money spent to get that advisor to “understand” your business (“Understand” is in quotes here because if their recent advice isn’t helpful then it’s arguable they don’t understand your business anymore.) But that’s not the best choice for your business. Successes of the past and the time and money invested in creating those don’t justify continuing something bad into the future. Your company needs great advice now, not yesterday.
Overcoming the Sunk Cost Fallacy
Recognizing the sunk cost fallacy is the first step to overcoming it. Here are some strategies to help you avoid this trap:
1. Regularly Reevaluate Projects: Periodically assess the progress and viability of ongoing projects. Are they meeting expectations? Are they still aligned with your business goals? If not, be prepared to pivot or pull the plug.
2. Set Clear Metrics: Establish clear, measurable criteria for success before starting a project. When you set a KPI, try to think of what numbers will tell you whether or not this is working. Having a metric in mind provides an objective benchmark to evaluate performance against, making it easier to recognize when it’s time to cut losses.
3. Consider Opportunity Costs: Every resource you pour into a failing project is a resource you can’t invest elsewhere. Always consider what you’re giving up by continuing with a suboptimal course of action.
4. Embrace Failure: In business, not every idea will be a winner. And that’s ok. Cultivate a culture that accepts failure as a learning opportunity rather than something to be avoided at all costs. This can help mitigate the emotional attachment to sunk costs.
5. Seek Outside Perspectives: It can be hard to let go of a project you’re personally invested in. Seek the advice of trusted advisors, employees, board members, or consultants who can provide an objective assessment. The team at Way Law would be happy to talk this through with you.
6. Separate Emotions: You are a great leader because you care. But to make objective calls about the sunk cost fallacy, you must remove your emotions from the decision. A project may mean a lot to you, or your team, which can make the thought of cutting it extremely difficult. The people aspect of the sunk cost fallacy can be extraordinarily difficult. Cutting a sunk cost fallacy may mean cutting a person from your team or a department’s budget. In times like that it is helpful to remember that your responsibilities are to the business and your team, not to this project. The project has no feelings and no loyalties. If it’s not working, let it go.
BUT, keep in mind, that letting it go is not always the optimal option. Some situations that may appear to be the sunk cost fallacy at work, are actually not. It’s important for us to know how to identify these as well.
What About Situations That Are Sunk Costs But Aren’t Sunk Cost Fallacy?
While the sunk cost fallacy is a common trap, it’s important to recognize that not every situation involving past investments is a sunk cost scenario. Here are a few examples where continuing a project might be justified despite significant prior expenditures:
1. Strategy Pivot: If the original strategy for a project was flawed, but you’ve identified a new approach that you believe will lead to success, additional investment might be warranted. In this case, you’re not continuing because of past investments, but because the future potential justifies further expenditure. The key is that the decision is based on a rational assessment of future prospects, not an emotional attachment to sunk costs.
For example, suppose you’ve invested heavily in developing a software product, but initial user feedback indicates that a significant redesign is necessary. If you believe the redesigned product has strong market potential, investing further to bring it to fruition could be a sound decision, even though it means adding to an already substantial investment.
2. Incomplete Information: Sometimes, initial investments are made based on incomplete or inaccurate information. As new data comes to light, what seemed like a losing proposition might turn out to have real potential. In such cases, the justification for continued investment comes from this new information, not the desire to justify past expenditures.
Consider a scenario where you’ve invested in a marketing campaign that seemed to be performing poorly. However, you later discover that there was an issue with your analytics setup, and the campaign was actually driving significant sales. Armed with this new insight, continuing or even increasing your investment in the campaign would be a data-driven decision, not a sunk cost fallacy.
3. Necessary Completion: In some projects, stopping halfway through might mean wasting the entire initial investment. If completing the project would deliver value that exceeds the additional costs, then finishing what you started could be the rational choice.
Imagine you’re halfway through completing the buildout on a new production facility, store location, or office. Stopping construction would mean writing off the money already spent. However, if completing the buildout would allow you to produce profitable products and services, then the forward-looking decision might be to see the project through to completion.
The Key Distinction
The crucial distinction in all these situations is that the decision to continue investing is based on a rational assessment of future costs and benefits, not any psychological compulsion to justify past investments. It’s not a sunk cost fallacy if your reasons for pressing onward are grounded in sound strategic and financial analysis of future benefits.
However, it’s important to be rigorous in your assessment and guard against bias. It can be all too easy to convince ourselves that a project has future potential when we’re emotionally invested in its success. Always strive to view the situation as objectively as possible and be open to input from those without a personal stake in the project.
The Bottom Line
The quicksand of the sunk cost fallacy is a costly mistake for businesses. It creates suboptimal resource allocation and poor decision-making. As a business owner, it’s crucial to recognize when you’re being influenced by sunk costs and to steer your thinking toward a more rational, forward-looking approach.
Remember, your goal is to make decisions that maximize your business’s future prospects, not to justify past expenditures. By understanding and avoiding the sunk cost fallacy, you can position your business for more efficient operation and better long-term outcomes.
Don’t throw good money after bad. If continuing on a path does not increase your likelihood of success, you may be facing the sunk cost fallacy. But if continuing, perhaps with a strategic or tactical pivot or the very nature of the project, offers a path to return, then you have a sunk cost but not a sunk cost fallacy.
The sunk cost fallacy will take your money. The key to not letting it is to identify sunk cost fallacy scenarios and act rationally once you do. Your bottom line will thank you.
When you need help making rational, data-driven, strategic maneuvers, Team Way Law is always here to listen and advise. We’ll go even further. We’ll make sure the sunk cost fallacy never applies to your legal relationship. Call us today!