What are Sunk Costs and Why do they Matter for your Business?

In this example, the architecture fees are an example of a sunk cost. It contacts an architect to design a new space who drafts some preliminary drawings for a fee. Then, an economy slowdown occurs, and the company is now unsure whether it should continue with the new warehouse.

This fallacy can result in further losses and missed opportunities. When making business decisions, organizations should only consider relevant costs, which include the future costs that still needed to be incurred. The relevant costs are contrasted with the potential revenue of one choice compared to another. To make an informed decision, a business only considers the costs and revenue that will change as a result of the decision at hand.

Why do people often fall victim to the sunk cost fallacy?

Going back to our medical school example, choosing to stay in the program would mean potentially doubling one’s student debt to complete coursework they aren’t genuinely passionate about. Commitment bias is the human tendency to stick with previous behaviors and beliefs. The sunk cost fallacy can prevent an individual or organization from acting in their own best interest. In this case, all the money invested in researching the feature would come under sunk cost.

Research and development

For many people there is little joy in playing these games anymore, but they still do because they’ve already invested so much time in it. Simply abandoning these games would make no sense to them, because it would seem as a loss. Essentially it means defending an investment you’ve made by investing even more. All though you have no specific reason for it other than your argument being your prior investment. I still kept refining the article because I already invested so much time in it. I was also emotionally invested in that topic for the last couple days, so I felt like I need to write about it for some reason.

According to Barton, ‘loss aversion’ is another struggle where business owners make poor decisions fearing wasting past expenses and disregarding current and future costs and benefits. In business, sunk costs are expenses that are already paid and can’t be recovered. This could include equipment, factory leases for manufacturing, marketing and software costs in service-based industries, or salaries. However, it is important to realize that not all fixed costs are considered sunk costs. In economics, a sunk cost is a cost that has already been paid and can’t be recovered.

1. People often feel compelled to continue investing time, money, or resources into a project or endeavor simply because they have already invested a significant amount.
2. This bias can result in suboptimal decision-making, as the focus is on past investments rather than future benefits.
3. He has worked on enterprise-level behavioral architecture at TD Securities and BMO Capital Markets, where he advised management on the implementation of systems processing billions of dollars per week.
4. If you find yourself justifying behaviour due to costs you’ve paid in the past rather than circumstances of the present, or predictions of the future, it’s worth checking yourself.
5. Imagine a company that has entered into a contract to buy 1,000 pounds of raw materials for the next six months.
6. Lastly, the frame may affect the expectations that people have about each other’s behaviour and will in turn affect their own behaviour.

People often fall victim to the sunk cost fallacy due to emotional attachment to past investments, fear of admitting failure, or a desire to avoid feeling regret over wasted resources. Additionally, cognitive biases can lead individuals to focus more on sunk costs than on future prospects. List out all the costs you’ll incur with each course of action you’re considering. Forget about what you’ve already spent (and this includes time and effort spent).

How do I prevent falling into the trap of sunk costs?

The sunk-cost dilemma involves deciding whether to continue a project with a significant sunk costs or abandon it entirely. Money that has already been spent or that has been formally committed to be spent is known as sunk expenses. All sunk costs are fixed costs but not all fixed costs are sunk costs. If equipment can be resold or returned at the purchase price, for example, it’s not a sunk cost. “All sunk costs are fixed costs, but not all fixed costs are sunk costs,” says Barton.

1. For example, a company may ignore market shifts that render their product obsolete.
2. Bob’s been thinking of upgrading to a bigger house (and they are now cheaper!), but will need to sell his existing house to have funds for a downpayment.
3. Sunk costs are excluded from a sell-or-process-further decision, which is a concept that applies to products that can be sold as they are or can be processed further.
4. Consider post-paid cell phone, or cable and Internet services.
5. The sunk cost fallacy is the human tendency to stick with endeavors in which we’ve already invested time, money, or other resources even when changing course would be the more logical choice.

Plan continuation bias

In 2001 Kodak, a example of sunk cost player, in the film photography industry invested in digital cameras. Unfortunately, they struggled to keep pace with market shifts. Their reluctance to let go of investments, in technology impeded their progress in embracing the digital photography era. A ticket buyer who purchases a ticket in advance to an event they eventually turn out not to enjoy makes a semi-public commitment to watching it. To leave early is to make this lapse of judgment manifest to strangers, an appearance they might otherwise choose to avoid. As well, the person may not want to leave the event because they have already paid, so they may feel that leaving would waste their expenditure.

After trading for Joey Gallo, the New York Yankees outfielder struck out 194 times over 140 games. Instead of continuing to stick with their decision that didn’t pan out as they’d hoped, the Yankees traded Gallo in August 2022. Salaries are a crucial business expense, but also a sunk cost, explains Barton.

Which means, any future decisions should not be affected by the sunk cost, because it’s already gone anyway. Yes, the sunk cost dilemma is prevalent in business contexts where investments have been made in projects, products, or ventures that are not performing as expected. Companies must often pivot projects, make capital allocation decisions, and make tough decisions on when to forgo continuing a project. For example, a company invests heavily in a product even when market research shows a decline in demand simply because they have already put so much effort into it. This tendency to stick with a failing project due to past investments is a trap that many individuals and businesses fall into. The sunk cost fallacy is the human tendency to stick with endeavors in which we’ve already invested time, money, or other resources even when changing course would be the more logical choice.

How to Avoid the Sunk Cost Fallacy

All houses are now cheaper by 20% and Bob can only sell his house for $800,000. Bob’s been thinking of upgrading to a bigger house (and they are now cheaper!), but will need to sell his existing house to have funds for a downpayment. Have you ever encountered a subpar hotel breakfast while on holiday? You don’t really like the food choices on offer, but since you already paid for the meal as part of your booking, you force yourself to eat something anyway rather than go down the road to a cafe. By launching a behavioral science practice at the core of the organization, we helped one of the largest insurers in North America realize $30M increase in annual revenue. Businesses may resist change even with changing market conditions or technological advancements, out of habit.

Sunk costs are excluded from future decisions because the cost will be the same regardless of the outcome. For product managers, sunk cost fallacy can cloud rational thinking. Evangelizing a new feature or product and motivating others around them are central to the PM role. Unsurprisingly, recognizing that a feature or product is no longer achieving its objectives after investing considerable time, energy, and resources can be challenging. The sunk cost dilemma is also commonly discussed when considering investments, primarily in volatile investments like equity markets. Investors that have limited capital must make decisions on whether to hold or sell securities and must make the decision independent of historical emotions.