Sunk Cost Fallacy: A Trap Leading to Irrational Decisions

Sunk cost is a term that describes an expense already incurred and can not be recovered by additional investment. Examples include marketing, research, and software installation just to name a few as these costs are irrecoverable. This principle extends beyond businesses and also applies to individuals in their day-to-day decision-making.

Sunk costs are considered irrelevant costs in the decision-making process as they do not impact future decisions. All future decisions of organizations or individuals should be based on relevant costs only, which include non-fixed future costs. According to the bygones principle, one should consider only the costs that change the decision they are making.

However, some people tend to base their decisions on the costs incurred in the past. This results in them making irrational decisions by spending more money on something no longer useful just because they had spent money on it in the past — in short, the sunk cost fallacy.

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Impact on businesses

Management that adopts a loss-aversive approach is more likely to be caught up in the sunk cost fallacy. The fear of loss due to expenses already incurred may lead to spending more resources on projects less viable. Therefore, a business can put itself at risk of creating a vicious cycle of spending more resources, resulting in huge losses due to not making timely decisions.

For instance, a business can spend considerable capital in the research and marketing phase. However, upon entering the operational phase, management may realize the project is potentially unviable. The logical conclusion is that the operations should be stopped immediately to prevent the business from any future losses. Unfortunately, most businesses fall into the malicious trap of sunk cost fallacy and keep investing instead, leading to huge losses.

'Sunk cost fallacy' is one of over 100 unconscious biases that can impact on our leadership and the way we do business@hayleybarnard pic.twitter.com/6TcZ9xAxKC

— School for CEOs (@SchoolforCEOs) January 26, 2017

Impact on individuals

Aside from businesses, the sunk cost fallacy can also affect a person as it is a psychological phenomenon commonly observed in our day-to-day decision-making. People are likely to persist in activities that are more of a financial and emotional strain, despite lacking to add significant value to their lives.

A practical example of the sunk cost fallacy is continuing to pay transportation costs and a monthly fee to a gym located far away from your home. Although unlogical, a person may choose to continue this due to several reasons such as the yearly membership already paid for. In the long run, it becomes not only a waste of time and money, but can also lead to emotional stress.

Avoiding the fallacy

The sunk cost fallacy can be avoided by adopting a conscious approach to decision-making. Businesses should make timely and accurate investment decisions, keeping in mind the sunk cost fallacy and its potential to impact the viability and profitability of a project. Management must recognize when to stop investing in projects that prove to be unprofitable to avoid further damage. Some AI tools may come in handy if you want to protect yourself or your business to avoid this.

Being aware of the sunk cost fallacy is crucial to the decision-making process, be it on an individual or business level. Once familiar with the factors that lead to sunk costs and the pitfalls of the sunk cost fallacy, one can focus on current and future costs instead of past commitments to make rational decisions.

YouTube: Sunk Cost Fallacy: Not Knowing When It’s Time To Stop

Photo credit: The image has been taken by Jp Valery.
Sources: Will Kenton (Investopedia) / Chris B. Murphy (Investopedia) / EconomicsKey.com / Alicia Tuovila (Investopedia) / Daniel Liberto (Investopedia) / Caeleigh MacNeil (Asana)