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

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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.

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Interview: Jim Mitchem on Entrepreneurship

May 8, 2018 Interviews Comments (0) 758

Jim Mitchem, an author and partner with branding firm Out of the Ether, and I explore starting a service business, the willingness to take risks, branding, continuous self-improvement, and many other things in this interview for my Everyday Entrepreneurs podcast.

 

You can listen below on Soundcloud or subscribe to the podcast on iTunesGoogle PlayStitcher, or wherever you get your podcasts.

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:

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The Friday Review

October 13, 2017 Friday Review Comments (0) 656

An occasional Friday post about random things and interesting finds.

Thinking.

The things happening in America right now trouble me in ways I cannot yet verbalize. I cannot help but think that the lack of critical thinking is at the root of many of our cultural challenges. This article in Edutopia, Overcoming Obstacles to Critical Thinking by Randy Kasten strikes a chord. I believe we need to start teaching critical thinking skills much earlier. Maybe we should start in elementary school. Would you agree?

 

Listening.

I’ve been shaking up my podcast listening lately. Among my new favorites are:

  • How I built this with Guy Raz. An interview show with successful entrepreneurs and others about how they built their movements.
  • Longform. Another interview show, but this one is with non-fiction writers who discuss their writing.
  • The Good Life Project Podcast. Jonathan Field’s interview-focused podcast exploring what it takes to live a good life.
  • Self-made man. Mike Dillard’s podcast about men who are striving for greatness.

 

Reading.

I finished Tyler Cowen’s The Complacent Class a few months ago. I’m still distilling my takeaways, and I will likely write a few posts about my thinking on his theories. In, It’s time to think differently about entrepreneurship, I did reference his thinking on cultural segregation and the possible impact on entrepreneurship.

With the required reading for my graduate classes, I’m finding it hard to get into reading much of anything other than magazine articles. Still, next up on my reading list are:

In case you missed it.

I just finished an 8-week graduate class in Advanced Entrepreneurial Finance. I’ve written a lot about business finance from an entrepreneur’s perspective. If you’ve missed those posts and are interested in reviewing them, they’re listed below. I have also included in several of those posts downloadable example spreadsheets for creating pro formas, calculating financial ratios, and determining customer acquisition costs.

There’s also a whole series on Angel Investment from a previous class that I failed to share. You can check those out here: Entrepreneurial Funding

Recently I interviewed  Gregg Smith, Founder of Evolution Business Advisors, Kim Stewart, SVP, Working Capital Solutions Advisor at BB&T about equity and debt financing respectively. Plus, I interviewed Rachael Harper, founder of Vida Calma Wellness for my new Everyday Entrepreneurs podcast.

In the Everyday Entrepreneurs podcast, I talk with entrepreneurs about what it’s like to create, build and grow a business. We examine the ups and downs of startups and small business, raise up the successes, and explore the failures in hopes of offering other listeners some insights on life in a small business.  Occasionally I will offer some tips and insights about the entrepreneurial life from my own experiences.

You can listen below on Soundcloud or subscribe to the podcast on iTunesGoogle PlayStitcher, or wherever you get your podcasts.

Thanks for reading. Have a great weekend!

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