After spending about $400,000 to implement and use Salesforce, 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 was exactly the situation a client of ShapeConnect was facing — a scenario that the business solutions platform sees all the time when helping companies match with vetted software platforms and service vendors.
“A lot of companies will get themselves into a position where they have hundreds of thousands of dollars sunk into a platform, and they know they need to make a change, but they don’t want to because the change is too big, or they just think, ‘Well, we have already invested over here. We don’t want to move on,’” said Mark Kennedy, chief information officer at ShapeConnect.
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.
“There’s a way that you can spin the sunk cost and make it not look like a sunk cost anymore ... There’s an ROI pot of gold at the end of the rainbow.”
“From a sunk cost fallacy standpoint, you think that it’s this sunk cost of $400,000 sitting back there, but really, you’re spending X amount of money every day trying to feed the beast that’s back there that you’re like, ‘Well, we can’t get rid of that because we’ve got so much money spent,” Kennedy said.
ShapeConnect ended up finding a new platform that helped its client streamline customer management, and ultimately saved them $170,000 per year in future licensing expenses.
“There’s a way that you can spin the sunk cost and make it not look like a sunk cost anymore,” Kennedy said. “There’s an ROI pot of gold at the end of the rainbow.”
Understanding Sunk Costs
Simply, 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.”
Baliga and another Northwestern professor conducted research examining two different ways that sunk cost fallacy plays out in business. The most common way people think about sunk cost fallacy is like the Salesforce example above, 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.
The other way Baliga said sunk cost fallacy can play out in business is what he 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 said. “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.
What Are the Potential Dangers of Sunk Cost Fallacy?
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.
General Assembly recently shut down some of its physical campuses where demand for in-person classes has decreased, pivoting to a remote-first educational model in some markets.
“We have 10-year leases in some of our markets, and so even if we decide we want to depart that market, there’s still going to be a financial hit that the organization needs to incur,” Bollig said.
Yet, despite the sunk cost of the lease expenses, the company can still save money by shifting its model for what’s best for the future of the business. Seattle is one market where General Assembly is no longer seeing enough demand for in-person classes to justify having a physical space.
“That money’s been spent. We can now continue to run course instances on-site there at a loss, or we can now shift to an online model, have bigger class sizes, which are better for our margin and also better for the student learning experience,” she said. “So, now, we are seeing a better ROI.”
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. “
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 Sunk Cost Fallacy Impacts Hiring in Tech
The sunk cost fallacy shows up daily in Crawford Hentz’s work as an HR executive and career coach. For instance, companies can be more inclined to keep around underperforming employees and put them on performance improvement plans just because they’ve already invested time and resources into this person.
“People say … ‘I don’t want to go through the cost of getting a new person and training them all up. I’ve already spent so many hours with this person trying to get them to the right place, and they’re doing fine,’” Crawford Hentz said. “But from a human capital management perspective, there’s an opportunity cost to allowing that sunk cost fallacy to inform your business strategy.”
On the flip side, Crawford Hentz said she’s also seen companies unwilling to pay retention bonuses for their existing employees, which is pushing some workers to find new opportunities.
“We’re seeing employers say to high-performing employees, ‘Well, we are paying you already top-of-market, so we’re not going to pay you a retention bonus,” Crawford Hentz said. “I think employers are using sunk cost fallacy to say, ‘Oh, that employee’s never going to leave.’ For such a long time, employers relied on loyalty … They’re using sunk cost fallacy like ‘We’ve invested so much in them.’ Yeah, and they can go somewhere else.”
Companies that fall victim to sunk cost fallacy are more likely to struggle with attracting new talent or competing in their industries, Kennedy said.
“I think the competitors will outpace them,” he said. “There’s definitely a portion of acquiring new talent in the organization. People don’t want to come work for organizations that are using old tools anymore.”
How Do You Avoid Falling for Sunk Cost Fallacy?
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.
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.
“Say thank you to that program, and then let it go. Say thank you to that company and then let it go ... You don’t have to keep feeding something that no longer serves you, even if it’s scary to walk away.”
“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.
Kennedy 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, Crawford Hentz said. She also suggests professionals could benefit from embracing organizing consultant Marie Kondo’s KonMari Method in terms of deciding where to continue investing their time and resources. The organization method calls for choosing to only keep items that “spark joy” or serve the person. If something is no longer of service or benefit, it can be appreciated for its past value, but it doesn’t need to be kept anymore. The same can be applied to business decisions.
“Say thank you to that program, and then let it go. Say thank you to that company and then let it go,” Crawford Hentz said. “You don’t have to keep feeding something that no longer serves you, even if it’s scary to walk away.”