Wow. Lots of email on the issue of not letting sunk costs figure into future decisions. Folks – here’s a clue for you. If your reaction is visceral, that comes from emotion, not reason. And that was precisely my point.
Business decision-makers are often bedeviled by their lack of schooling in economic theory. Economic concepts are the science that form the foundations of business, and without them, decision-makers can only rely on experience, observation, emotion and gut feelings. What’s wrong with using experience and observation? Experience is useful to the extent that it is relevant, but changing even one condition or assumption can render previous experience useless. Observation is far from reliable, because it is limited by both conceptual bias and limitation of sample (i.e., what one customer complains about may be something that 2,000 of them like – but the complainer gets the attention, because they are the one “observed”). Emotion and gut feelings must be treated as if they are flawed until proven otherwise – I don’t care HOW much EQ you think you have.
So how do we counter flawed assumptions, conceptual bias, limitation of sample, ego, emotion, and gut feelings? With sound principles tested over time. Get out your microeconomics text book, because just for kicks and giggles, we’re digging deeper into the idea of sunk costs. This is just one example of how understanding microeconomics (and behavioral economics) is important for business people at every level.
The definition of sunk cost is a cost that has already been incurred and which cannot be recovered regardless of future events. When someone continues to support a losing financial proposition because they have “already put so much money into it, and if I don’t keep going that investment will be lost” they are engaging in sunk-cost fallacy. Why do they do this? Behavioral economists suggest two reasons: inappropriate ego involvement and aversion to waste (which is called loss avoidance).
Imagine you open a Pizza Pizza franchise, and your original investment is $32,000. Four months after you’re up and running you are not even close to making your numbers, because there is so much pizza competition in your community. You are losing $2,000 each month. An opportunity to open a Chik-a-Sandwich franchise falls in your lap – total investment $5,000. There are no chicken sandwich specialties in town, Chik-a-Sandwich has an incredible reputation, and they are willing to guarantee profits of $4,000 each month from month two. Only an irrational person would keep investing in the pizza franchise even though abandoning it represents a complete loss of the original investment (yes, and for the sake of example, we’re assuming there’s no risk of lawsuit here). An economist would argue that abandoning the $40,000 ($32k investment + $2k lossX4) represents one loss, whereas continuing to invest in the pizza franchise represents two losses (original investment and losses PLUS ongoing losses) as well as the third loss of opportunity (Chik-a-Sandwich profits).
“But wait!” you say. “The pizza franchise could be turned around!” Well, maybe it could. And if you have really excellent supporting evidence that something significant will change if you continue to invest in the pizza operation, then you might have a good argument for staying. All I’m saying is, it’s your money. Why would you want to con yourself out of your own money? Besides, there is good research data backing the idea that sunk cost fallacy is consistently supported by something called overly optimistic probability bias (Knox & Inkster, 1968), which means that once people have made a financial commitment to something, they assign irrational probabilities of success to it.
The field of economics assumes that reason will be present in decision-making. But economic research has demonstrated that sunk cost fallacy is so common that economic rationality is limited. Not only are the implications for business performance significant, but the impact on finance, economics and securities markets is concerning as well. Check out this excellent article on boiled shrimp to get the investor’s view of this issue. I’ll stick to the business angle.
OK, I promise I’ll write about something different tomorrow. But don’t you think any information that keeps us from throwing good money after bad should be considered? It freaks me out that this is one of the most common business mistakes, when it’s so preventable.
(c) Andrea M. Hill, 2007