Many business owners experience decisions that deal with sunk costs. For some, it may seem like too much of a risk to lose money, so it may be bettter to cut losses before a situation escalates. It's best to make the appropriate decision for your business.
All of us have dealt with sunk cost at some point, but may not have realized it at the time. Here’s an example.
You buy nonrefundable, advance tickets to a play that can’t be resold. Your out-of-pocket cost is $50. A few days later you hear from several of your best friends that the play is horrible and not worth seeing. If you still go to the play, you’re faced with spending another $50 for a babysitter, gas for the car, and parking at the theater. What would you do?
Many people would decide to go because they feel they have to “get their money’s worth,” even if that means sitting through a show they don’t like. If that happens they’ve compounded the monetary loss by losing a few hours of their time, an opportunity loss they’ll never get back. The decision is rationalized by the need to avoid “wasting” the initial $50 investment, at any cost. So they go, hoping their friends are all wrong.
Definition
The $50 for the tickets in this example is a sunk cost. Once a cost has been incurred and can’t be recovered, it’s a sunk cost. Whether or not you go to the show is irrelevant to that fact. Sunk costs are completely independent of any event or additional expenditure that may occur in the future.
This concept applies to your business as well as your personal life. There’s a significant psychological barrier to ignoring sunk cost when making decisions of all kinds.
Application
Once you invest money into something, there’s no reason to invest more money if recovery of the initial investment is unlikely. Another way of saying this is that you should avoid throwing good money after bad.
In the example above, if you don’t go to the play you’ll lose $50. Human nature dictates that most people will avert loss under almost any circumstances. Instead of making decisions solely on the merits, they’ll consider a host of other factors that veer from a purely economic solution that considers only variable costs.
If you go to the play and don’t like it, you’ve now upped your loss to $100. Does that make sense given the warnings from friends that have tastes similar to yours?
Distinguishing Sunk Cost
Some costs you incur may have no tangible benefit, but that doesn’t mean they’re sunk costs. A good example of this is the premiums you pay for business insurance. For many businesses, these premiums amount to thousands of dollars over a period of years without ever filing a claim. You can’t consider that sunk because you gained the benefit of protection from potential losses. Those fortunate enough not to experience such losses are not wasting their money by buying insurance.
Dilemma
Many homebuilders over the past few years have had direct experience with the sunk cost dilemma. Assume that during the housing bubble, you started work on a new development with 30 spec homes. You’ve done all the site prep and started construction on the first 10 homes when the market starts to crash.
By the time the homes are half completed, the housing market is collapsing all around you. You’ve got several hundred thousand dollars invested in the project and now you’re faced with a critical decision. Do you invest even more money and finish the project, hoping for a quick turnaround in the market? Or, do you ignore your sunk cost, stop work and save the additional money it would take to complete the construction?
Most people would find it difficult to walk away from an investment this large. The real-world dilemma posed in this case is a stark choice between certain loss and uncertain success. If you stop work, your sunk cost is essentially lost forever unless you can find another builder to take over the project. That’s not a likely prospect given the depth and breadth of the housing collapse.
If you ignore the sunk cost and keep working, you face the possibility of losing even more money it you can’t sell the homes fast enough to pay your bills. Gambling on an economic recovery could lead to bankruptcy and possibly the loss of your entire business. The only way to resolve the dilemma is to stop work or finish the project.
Making Decisions
Every business incurs sunk cost at some point. When faced with a decision to ignore sunk cost, one approach suggested by many economists is to “act on the margins.” The idea is to make a list of potential choices along with the benefits and additional costs associated with each, essentially a cost/benefit analysis. This forces you to focus on the future and will help you choose the option offering the maximum net additional benefits.
By basing your decision on the relative merits of each option, you’ve set the past aside and made sunk cost irrelevant to your decision. The amount of sunk cost won’t change regardless of what you do.
Summary
If decisions were entirely made on a rational, economic basis, sunk cost would be very easy to deal with. The reality is that psychology and human emotion often play a large role in our decision-making process. We’re tempted to ignore the numbers, take calculated risks and go with our gut instincts. Sometimes this works, only serving to validate our belief that we know better than the facts staring us in the face.
Many business owners routinely face decisions that involve sunk cost. The successful ones have adopted their own strategy for evaluating alternatives before they’re faced with a crisis requiring them to shoot from the hip. You’re not the only one who’s determined to avert losses, but sometimes it’s best to cut your losses before they get worse. Step back, regroup, seek good advice and then make a sound decision based on the best available data.
