What is Sunk Cost Fallacy and how does it impact your business?

Imagine that you spent Rs.5,000 a few weeks ago to buy a match ticket. On the day of the match, it starts raining. It is also a weekday, and you know that roads will be jam-packed. Despite all these facts, which seem to outweigh the benefits, you still choose to go to the match. This decision that we take is known as the sunk cost fallacy.

The fallacy is simple, and it suggests that a person is likely to go ahead with a decision, venture, continue consuming, or pursue an option if they have invested in it. This investment can be of time, money, or effort. It suggests that we can go against evidence that indicates that our decision may no longer be the best idea.

Sunk Cost Fallacy example — Sunk Cost Fallacy

Index:

What is sunk cost?

Sunk costs are costs that a person or a business has already incurred. And an investor cannot recover such a cost by using all possible means. Simply put, In business, suck cost is the money spent to make money.

This cost must not be considered while making any future business decision since an investor cannot recover it. Instead, businesses must only rely on relevant costs to make any decisions. Here are some examples of sunk costs, money spent on Marketing study, Research and development, and training.

Check this animated video to gain more insight:

How does the fallacy apply in business?

The sunk cost fallacy in terms of a business is the belief in an investor’s mind that they must make an additional investment in a project or business, or else the earlier investments will be wasted. This belief is considered deceptive, as it encourages investors to invest money in a project continually. These projects may or may not bring any possible return that can be the equivalent of the money they have spent as an investment.

For example, a person invests Rs.10,00,000 in a pilot project to manufacture mineral water in glass bottles. But the results show poor to no profitability in the future.

Under such circumstances, the logical choice would be to shut down the project. However, as per the sunk cost fallacy, a person will continue to pour in funds in a venture or project with the hope of turning a profit in the future.

How the Sunk Cost Fallacy Manifests in Business?

Product Development: A company may continue to invest in a failing product because they have already spent significant amounts on research and development, even if market feedback indicates low potential for success.
Projects and Initiatives: Businesses might persist with projects that are over budget or behind schedule, justifying the decision by the resources already invested, despite poor forecasts for future success.
Marketing Campaigns: Companies might keep funding ineffective marketing campaigns due to the high costs already incurred in planning and initial execution, ignoring the poor returns on investment.
Mergers and Acquisitions: After acquiring another company, a business may continue to pour resources into integrating or supporting it even when it becomes clear that the acquisition is not providing the expected benefits.

Examples in Business History

Concorde Supersonic Jet: Despite massive cost overruns and limited commercial success, investments continued due to the high costs already incurred.
Blockbuster: The company continued to invest in its traditional video rental business despite clear signs of industry shift towards digital streaming, leading to its eventual downfall.

Why does it happen?

We are all likely to be victims of the sunk cost fallacy as many of us are not purely rational decision-makers. Sunk cost fallacy is based on the fact that our emotions often influence us. If we have invested previously, we will likely feel bad or regretful if we do not follow through with that decision.

The fallacy is related to a commitment bias, where a person continues to support their past decisions despite evidence suggesting that it isn’t the right course of action. Investors often fail to consider that the time, effort, and monetary investment that has already been made cannot be recovered. As a result, investors base their decisions on past costs instead of present and future costs or benefits.

Another factor that can explain the mechanisms behind the sunk cost fallacy is that humans are more sensitive towards losses than gains. Additionally, the loss aversion effect may have a role to play too. Loss eversion can be understood as when a difference between two options is viewed as a difference between two disadvantages; the difference will have a significant impact.

In simple words, humans are risk-averse when faced with chances of future gains. A good example will be when an initial investment is made in a business, and the returns or outcomes of the same are unknown or negative. As a result, an individual is likely to invest more in the business to escape a disadvantage or negative effect.

Why should we be aware of it?

If you are coming up with a new business or brand, you must be aware of this fallacy as it impacts many vital aspects of our lives that have long-term effects. The sunk cost fallacy suggests that you are making decisions irrationally.

You are more concerned about your past investment instead of the present or future costs. Thereby you are committing yourselves to decisions that are no longer in your favor. The sunk cost fallacy can be a vicious cycle for any business investor; the more you invest, the more you feel compelled to continue with the project. You are more likely to lose resources as you follow through with your decision.

How do you avoid it?

In theory, companies and big businesses must act rationally, keeping in mind their economy and self-interest. But as humans who manage such businesses, we are likely to succumb to irrational thinking. While it is challenging to avoid our inherent and human cognitive fallacies, we must always try to ensure that you are not distracted by past commitments as investors in a business or a new startup.

Instead, it would be best if, as an investor, you focused on your present and future costs and benefits. Consider the following tips if you want to save yourself or your future business from sinking before sailing:

The best way is by admitting that you have been doing things the wrong way and start to cut your losses.
Educate and remind your managers that good management is about getting great results and not about saving faces.
Educate your partners, managers, and employees about the sunk cost fallacy.

Why do new businesses need to be extra cautious?

Established businesses with strong financial and technological backing may afford a few fallacies like these. But for a new or emerging business, the slightest miscalculation can lead to considerable damages.

New businesses have restricted resources; therefore, it is better to be rational about your decisions and investments. Pay attention to data and analysis over emotions. Time is the most valuable resource, and in this competitive world, you cannot afford to come second.

A final word:

As humans, we are designed to consider the past while making decisions for the future. However, it would be in your best interest as an investor if you did not continue with something simply because you have invested your effort, time, and money in it, as it often leads to plenty of bad choices.

As a result, we continue to operate well past the point where we should have pulled the plug. We waste time, money, and hope for a miracle when logic and data suggest that it’s time to change and not waste time and precious resources.

As a successful business person, you should function with rationality and not let emotions take the better of you. While it is great to be passionate about what you do, it is not always great to be emotionally invested.

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