The Entrepreneur and the Sunk Cost Fallacy

May 25, 2018 Change, Entrepreneurship Comments (0) 160

If you’re an entrepreneur and you’re not familiar with the term “sunk costs” you may have a problem.

A “sunk cost” is any past cost for something that you’ll not be able to recover. Typically, sunk costs are not included when making forward-looking decisions because those costs will remain the same regardless of what you may choose to do. In manufacturing, for example, a sunk cost might be the cost of equipment because it is a cost that has been incurred which will remain constant regardless of whether that equipment produces any product.

Think of it this way: It’s money you needed to spend that you’ll never get back.

The problem for most of us is that our forward-looking decisions become too tied to those sunk costs. We often become emotionally invested and the more investment we make, the harder it becomes to divest ourselves from those costs. In these situations, it is difficult to consider the pros and cons objectively. Instead, we try to recoup sunk costs, which makes us do irrational things.

Researchers Hal Arkes and Catherine Blumer argue that when we continue a behavior or work because of our previous investments of time, money, or effort, we fall victim to what has become known as the sunk cost fallacy (Arkes & Blumer, 1985). We place such a high value—either monetarily or emotionally—on those investments that we irrationally behave when faced with a decision that devalues those prior investments. Moreover, we look for ways to justify our choice rather than accepting the sunk costs as what they are—money we can never recoup.

Let’s look at it a more personal way.

Say you bought a quart of your favorite yogurt at the grocery store. It’s been in the fridge for a few weeks unopened, and putting away the dinner leftovers you spot it and realize that yesterday’s date is the “use by” date on the package. Concerned that it will spoil, you open and eat as much of the yogurt as you can—maybe even all of it—even though you’ve already had dinner because you’d rather do that than “waste your money” on food that will spoil.

The money for the yogurt was gone several weeks ago. You’re not going to get it back. But you’re emotionally invested with your favorite yogurt and your money. So, you chose to load up on the yogurt, which you didn’t enjoy as much this time. You only felt bloated and uncomfortable in the end. You made a decision that left you uncomfortable because of your emotional tie to money and your yogurt.

Make sense?

Consider another example. If you’re an artist, you invest a lot of time and energy in creating art. You might even have an MFA, so you have those education costs and maybe student loans to pay back. The time and energy to earn the degree, and the cost of your education are sunk costs. You will never get that time, energy, or money back. And still, you may be inclined to factor all those costs into the sales price of the art you create because you’re emotionally invested in those costs. But in doing so, your art rarely sells, or sells very slowly, because trying to recover the sunk costs will likely price your work out of range for your market. What you should really be doing is setting the price for the art based on the current market value of the art and perhaps the incremental costs to create it—paint, brushes, canvas—rather than all of the costs—sunk and incremental—you have invested in the artwork.

It.’s important to remember that sunk costs can occur in any situation where what is invested cannot be recovered in any way. Sunk costs can be the 30 years we spent in an industry that has since evolved beyond our experience, skills, and perhaps relevancy, for example.  Or trying to prove you are right about something when being right doesn’t matter. Maybe even ending a partnership that has long outlived its usefulness to all parties, but you keep hoping things will improve. Or maybe, doing everything you can to save a failing business because you’ve invested so much in it, hoping that things will turn the corner if you don’t quit. Those decisions are all based on the sunk cost fallacy and will become one of the causes of failure.

Making decisions about the future by basing them on backward-looking decisions of investments time, money, or effort, do not move the business forward. And many of us are guilty of spending too much time in the past for fear of wasting our investments. Psychologist Robert Leahy suggests that human beings fundamentally hate the idea of wasting anything. We have a desire to prove we’re right, we fear regret, we don’t want to feel bad, and we are unable to anticipate the positive side of giving up on the past or how others may view us if we chose to give up (Leahy, 2014).  I would argue that for entrepreneurs, this is all about overcoming the social stigma of failure, a risk that every entrepreneur faces when he or she steps into the ring.

No one likes to fail. But it takes many entrepreneurs a long time to admit that they are failing, or have failed, especially if that failure is not public. Even in the midst of a failing business, many entrepreneurs don’t seek the help they may need, often for fear of judgment. Failure suggests you didn’t do your homework—you misjudged the market, the opportunity, the customers. Perhaps it suggests you didn’t manage your budget well, or couldn’t keep your employees motivated. Those things could be true, but it is just as likely that you have been—conciously or not—making forward-looking decisions that factor in your sunk costs. And putting sunk costs in proper perspective can make all the difference between swimming with the sharks, or being eaten alive.

References

Arkes, H. R., & Blumer, C. (1985). The psychology of sunk costs. Organizational Behavior and Human Decision Processes, 35, 124-140. Retrieved May 24, 2018, from https://pdfs.semanticscholar.org/e456/4b88ca2349962a707b76be4c75076ad6bd43.pdf

Leahy, R. (2014, September 09). Letting Go of Sunk Costs. Retrieved May 24, 2018, from psychologytoday.com: https://www.psychologytoday.com/us/blog/anxiety-files/201409/letting-go-sunk-costs

_________

Image source:  GEORGE DESIPRIS from Pexels

David Harkins is a serial entrepreneur with significant experience in branding, strategy, licensing and marketing.

In his spare time, he consults, coaches, speaks, writes, hikes, explores, and creates art. Although, not necessarily in that order.

Connect with him on social media below:

Continue Reading