What Is a Sunk Cost?
A sunk cost refers to a cost that the company has already incurred and there is no way of recovering it in the future. Sunk costs come in many forms and can include rent, marketing expenses, research, payroll, employee benefits, investment in equipment, or new software installation.
Sunk Cost Fallacy
The sunk cost fallacy refers to the decision to keep throwing money into a project with the hope that this new investment will help recoup the initial cost simply because you have sunk so much money in it already. It’s important to note that sunk costs themselves are not necessarily negative but putting too much weight on these costs when making decisions usually is.
The fallacy is often used in business to refer to situations where management wants to keep investing in a project that they have already heavily invested in simply because they have put a lot of money into it already, no matter its outlook.
To not make this kind of mistake, it’s important to compare the direct estimated returns of projects to determine their worth when making financial decisions, not just the costs they have racked up already.
The sunk cost fallacy is found in many other realms outside of business like in romantic relationships. Partners are less likely to split up when they have spent years and years together and put a ton of effort into mending their relationship, even when they both know that it won’t and can’t work out.
Factors That Contribute To Sunk Cost Fallacy
There are a few factors that can drive a business to fall into the trap of the sunk cost fallacy. They include:
- Loss aversion: This is the tendency to sidestep a loss in favor of an equivalent gain.
- Overoptimistic probability bias: This is the belief that cost has a positive impact on future returns on investment.
- Perception of Wastefulness: Some managers do not want to paint the picture of wasting time on some projects or investments and be judged for it. So, they continue to pump money into struggling investments instead of discontinuing them.