Sunk cost, and the sunk cost fallacy.
What are sunk costs, and how do we avoid getting trapped by them, in business as well as other
areas of life.
Let’s start with the financial perspective on “sunk cost”.
Where in the profit and loss statement can we find a line item called “sunk cost expense”?
Let’s take a look at an income statement, or profit and loss statement.
Sunk costs are not a separate line item, they could occur in any place on the income statement
or the balance sheet.
Sunk costs is not really a literal finance or accounting term that can be found on an
income statement.
Sunk cost is an economic and psychological concept, that is part of decision making.
An example of sunk costs in business.
Jane has recently made a promotion to site manager of a production location.
She is very happy.
The job comes with a lot of responsibility, as key product lines of the company are manufactured
at and shipped from this site.
On her first day on the new job, Jane makes a factory tour and meets key production personnel.
She notices that one machine is disassembled into pieces,
and asks what is going on with this equipment.
She gathers some facts about the broken machine.
The machine is already 75% depreciated, with 25% of the original book value still “to go”.
Due to frequent breakdowns, the machine has had excessive maintenance cost versus other
production equipment.
The downtime had led to late shipments to customers, and customer complaints.
There is no permanent solution in sight to fix the erratic performance of the machine.
Jane is a rational business leader that bases her decisions on facts, and the reality of
a situation (however grim things might be).
She notices that the team has put a lot of time, money and effort into trying to get
this machine back up and running.
But that really is all sunk cost.
It cannot be recovered.
What is the best way to go forward, to maximize the performance of the manufacturing site
and the business?
Jane checks with her finance manager, as well as corporate headquarters.
After careful consideration, she initiates a write-off of the remaining book value of
the machine, has the broken machine removed, a new machine purchased and installed, and
is able to get production and shipments back on track!
Jane is very rational and decisive in a business environment, but not as well balanced in other
domains such as her romantic relationships.
Jane met Jim a few years ago, they fell madly in love, and started their relationship in
high spirits.
Over the years, the initial euphoria has died down, to the point where Jane asks herself
whether there is any basis left for continuing the relationship.
The facts about the broken relationship are that Jane and Jim have different life goals,
different day-to-day habits, no plans to get married, and no kids.
This relationship situation might be very similar to the business situation that Jane
just faced.
Are you continuing only because you don’t want to have past investment go to waste?
Jane decides that she has to have a talk with Jim.
Which choice is going to produce the best outcome
for our (individual or collective) future?
Would we want to start this relationship today, based on what we know today, and the people
we are today?
The concept of sunk costs doesn’t just apply to business or relationships.
See if you ever made any of the following statements.
If so, you might be a victim of the sunk cost fallacy or sunk cost trap: sticking to a prior
choice, even though you should know that the time, money and effort invested in the past
cannot be recovered.
In the context of career, did you ever say: “This is not a job where I can fully utilize
my strengths and skills, but I have spent 10 years building this career so I must stay”.
Or in the context of education, “This is not a direction I want to pursue, but I have
already spent 2 of the 4 years on the curriculum, so I should finish it”.
Or when reading: “I am not enjoying this book, but I already read the first 100 pages,
so I will continue for the remaining 700 pages”.
The sunk cost fallacy often motivates people to do things based on how much time or money
they have already invested, even though they don't want to do them!
The reality of sunk costs is: in many areas of life, there are no refunds or exchanges!
Sunk costs (time, money, effort) should be irrelevant to future decisions.
Sunk costs have already been incurred and can’t be changed!
The better question to ask is: which choice is going to produce the best outcome for the
future, based on the future investment and benefits I expect?
I hope you enjoyed this short discussion of sunk cost.
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