A sunk cost (or "retrospective cost") refers to money that has already been spent and cannot be recovered. This could be money that you've already spent on property or land that you are soon going to develop or renovate, or that you've invested into the early stages of a new business venture and bought items that you're now stuck with.
It differs from a "prospective cost" which are potential costs in the future that can be avoided if action is taken.
You've probably heard the phrase "throwing good money after bad"? The idea that you continue investing time and effort and money into a project, even though continuing it is not a wise choice.
The economic term for that is "Sunk Cost Fallacy".
Sunk Cost Fallacy happens when a business decides to continue to invest time, effort and especially money into a project that it has already invested a huge amount into, despite there being no economic positives to be gained from continuing to fund the project. It is a critical error in reasoning that any decision-maker should aim to avoid.
There may be other factors that can also play a part here:
Commitment bias - where we tend to support our past decisions, even when new evidence shows that they weren't the best decisions to have made in the first place.
Loss aversion - the impact of loss feels much worse than the impact gains have on us, so we're more likely to avoid losses than seek out gains. Perhaps a past investment might be lost if we don't follow through on our decision, and then we make a future decision based on loss aversion rather than consider the benefits that come with choosing a different path to our original investment.
Fun fact - this is the reason why Concorde failed. The British and French governments took their past expenses on the highly costly project as the rationale for continuing the project, even after it became apparent that there was no longer an economic case for the aircraft. Governments could have decided to cut their losses, but political and legal issues ultimately made it impossible for either government to pull out.
Why does this happen?
To put it simply, it happens because we are humans and businesses are run by humans. Humans are not rational decision-makers. Our emotions cause us to deviate from rational decision-making, and we feel resentful and guilty and wasteful if we don't follow through with a venture that we have poured resources into. Since we're more likely to make decisions that avoid losses rather than make decisions that can bring us gains, we're more likely to follow through on decisions we've made and investments we've already made, even if they're not in our best interests.
What does this look like in real life, though?
Analogy 1
You go to a restaurant and you order a meal for £20. You receive your meal and you start eating it, but after one bite you realise that its not a good meal at all!
But you've invested £20 of your hard-earned money into that meal, so you decide to carry on eating it anyway because you've spent the money on it already.
But if you didn't continue to eat the meal, then you'd feel like you've lost the money that you've invested into receiving what you hoped would be an enjoyable meal, even though you're not enjoying the result of your investment (ie, the crappy meal!).
SUNK COST FALLACY!!
Analogy 2
You work for years to achieve what you decide you're going to achieve for your career. This could be to become a lawyer, accountant, doctor, whatever. But along the way you realise "I'm not enjoying this as much as I thought I would". It could be for any reason - the places you've worked at were toxic, you're not enjoying the subject matter, you're not getting the most out of your training, you feel you can't balance work and life, or something else entirely.
But you continue on because you've spent so much time, effort and money on the training journey that you feel like it would be wasted if you simply "gave up" and did something else with your life that could make you happier, more money, or more time.
SUNK COST FALLACY!!
There becomes a tendency for decision-makers here to put more focus on what they are going to lose in a decision rather than what they stand to gain. We're all guilty of it, regardless of if we're in business or not.
Is there a way to avoid it?
Simply being aware that Sunk Cost Fallacy is a thing is often the first step to avoiding it. Treating the beast like it exists means you know there's a beast to avoid.
By being aware of it, it makes it easier to focus on current and future costs of a venture or a project, rather than past costs, commitments and things that can't be changed now, and the feelings of guilt and resentment that often comes with dropping a commitment.
But emotions are hard to ignore, particularly when a project or a venture means so much to us, and they can have a huge influence over our decisions.
To eliminate emotions from decision making, options can include:
Using tech to make an objective, emotionless, and rational choice of action
Bring on a project manager, someone who can be objective
I read the antonym of Sunk Cost Fallacy as being "cutting one's losses" where you essentially refuse to put any more investment into something that you knew is failing and you know is going to continue to be a burden on your time, effort and money. You've probably made a loss anyway, but by cutting your losses, you can avoid any further losses.
But again, this is difficult because of what has been mentioned above around humans making decisions to avoid losses rather than to chase gains. The idea that we would abandon a project or venture knowing that we've poured time and effort and money into it is a difficult pill to swallow
If you want to learn more, check out these further resources:
Credit: Cover image photo by Emily Morter on Unsplash
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