After spending lots of money to implement new software, a company might be hesitant to switch vendors and purchase a brand new platform, even if a new software would better fit the organization’s needs.
That thinking is an example of sunk cost fallacy, the idea of continuing to dedicate time and resources into something because of previous investments in it, even though the more beneficial course of action would be to stop or make a change.
What Is the Sunk Cost Fallacy?
The sunk cost fallacy is a phenomenon that occurs when someone chooses not to switch from a strategy or behavior that has been heavily invested in, even when it would be more beneficial to do so. A decision not to abandon a strategy comes from the thought that a large amount of resources — such as money, time and effort — has already been contributed to the cause, and that changing the strategy would result in sunk costs.
Indeed, sunk costs are expenses that have already been incurred and can’t be recovered, like the cost of research and development for a new product, said Sandeep Baliga, a professor of managerial economics and decision sciences at Northwestern University’s Kellogg School of Management.
“Sunk costs are basically just unavoidable,” Baliga said. “So, it’s pretty important to get your decision-making right.”
How Does Sunk Cost Fallacy Affect Businesses?
Baliga and another Northwestern professor conducted research examining two different ways that sunk cost fallacy plays out in business.
1. Overproduction or Too Much Investment
The most common way people think about sunk cost fallacy is like the example in the introduction, sometimes called the Concorde effect (in reference to the supersonic jet that the British and French aircraft manufacturers continued to invest in despite its financial failures). That type of thinking leads to overproduction or too much investment in an idea.
2. Underproduction or Project Cancellations
The other way the sunk cost fallacy can play out in business is what Baliga calls the pro rata effect. Taking into account the sunk costs and fixed costs when considering future production expenses can lead to underproduction or prematurely canceling projects. That’s just wrong in terms of microeconomics principles, he said. Only variable costs should be accounted for in pricing.
“We basically show how limited memory could generate both these issues in different circumstances,” Baliga added. “Limited memory could happen with just one person forgetting why they started something. It also happens because people leave the company.”
For example, limited memory could contribute to sunk cost fallacy if the profit forecasts determined prior to a project are forgotten, and the decision maker continues a project by justifying expenses based on what they presume to be a high profit forecast, Baliga said.
Potential Dangers of Sunk Cost Fallacy
Loss of Time and Money
Sunk cost fallacy can cost people and businesses a lot of time and money if they are continuing to invest in ideas or projects that aren’t working anymore.
“I think the reason people cling to sunk costs even when they’re not good decisions is because they perceive it as being expensive or a waste of money to walk away from something, and it is the exact opposite thing that is true,” said Chris Bollig, senior vice president of campus operations and programs at General Assembly, an edtech company that offers technology training.
Can Be Risky for Starting Businesses
Sunk cost fallacy can be especially detrimental to early-stage startups that are working with limited resources.
“Most of the startups have three, four months’ worth of cash, and that’s it,” said Ivan Gekht, CEO of software development company Gehtsoft. “So, if you double down on the wrong theory, in four months, you’re out of business.”
Can Prevent Company Advancement and Growth
Sunk cost fallacy can prevent advancement and growth — whether it be a company clinging to an outdated technology or an employee being afraid to pursue a new job opportunity because of their past investment in an organization.
“It’s putting much more weight on the investments of the past than the thinking of liberating yourself from those investments in the future,” said Maureen Crawford Hentz, a vice president of HR for a manufacturing company and career coach for Bravely.
How to Avoid Falling for Sunk Cost Fallacy
Use Agile Practices
Using agile practices helps Gehtsoft avoid sunk cost fallacy, Gekht said. By working in shorter cycles, the company has more opportunities to adjust to feedback and avoid investing in practices or projects that aren’t working.
“Our ideas can be wrong. How soon can we check if we are right or wrong? How soon can we verify our hypothesis, and then make the decision?” Gekht said.
Document Business and Project Finances
Reducing limited memory can help avoid sunk cost fallacy, so write and record as much as possible when starting a new business or project, Baliga said. Document profit forecasts, costs and all financials, he said.
“You can revisit it and say, ‘Oh, is this rationale that we wrote down just wrong?’ And then if it’s wrong, then you can cancel the project,” Baliga said.
Keep Decision Making Unbiased
Mark Kennedy, chief information officer at ShapeConnect, suggests trying to keep decision making as unbiased as possible — emotional decision making can push people toward sunk cost fallacy.
Look at any implicit biases that might be dictating your decision making, suggests Crawford Hentz, an HR executive and career coach.
“You don’t have to keep feeding something that no longer serves you, even if it’s scary to walk away,” she told Built In.
Frequently Asked Questions
What is the sunk cost fallacy?
Sunk cost fallacy occurs when someone continues to carry out a behavior or strategy because they have invested money, time or effort into it, even though abandoning it would be more beneficial. The choice not to change behaviors often comes from a fear of incurring sunk costs.
What is an example of a sunk cost fallacy?
Some examples of sunk cost fallacy include going to a concert you don't enjoy because the ticket has already been bought, or choosing to keep investing in a certain tool at work due to already using it for years.
How do you avoid sunk cost?
Sunk costs and sunk cost fallacy can be avoided by tracking spending and finances, using unbiased decision making and reflecting on decisions often.