Do you ignore sunk costs when making decisions? Then you may be at risk for getting trapped in the sunk cost dilemma.
What Is A Sunk Cost?
A sunk cost is money, time or another resource that has been irretrievably spent. The hour you spent yesterday playing solitaire or the money you spent on dinner last night are sunk costs. You can never get that hour or money back.
Costs in the past are usually sunk costs, though not always. If you buy a sweater for your niece, you can return it and get a refund if it doesn’t fit. In this case, the cost is a retrievable cost rather than a sunk cost. It becomes a sunk cost only once the return period has expired.
Costs in the future can be sunk costs if they are, for all practical purposes, inevitable. If you sign a contract requiring you to pay $100 a month for a year, and there’s no way out of the contract, that $1,200 is a sunk cost because you’re legally obligated to pay the money. While you could default or declare bankruptcy, that usually isn’t an option.
Costs that depend on the decisions you make are called avoidable costs. Before you buy a car, you have the option of avoiding that monthly loan payment. Once you sign, that payment becomes a sunk cost. Recurring or fixed costs, like salaries and loan payments, are often considered sunk costs, since your decision does nothing to prevent the cost.
Though whether a given cost is sunk or avoidable depends on the decision. If you’re deciding whether to sell your car, your loan payments may be an avoidable cost rather than a sunk cost. And as mentioned above, costs preventable through bankruptcy or default are generally considered sunk costs, even if they can technically be avoided.
Ignoring Sunk Costs
Rational thinking dictates that we should ignore sunk costs when making a decision. The goal of a decision is to alter the course of the future. And since sunk costs cannot be changed, you should avoid taking those costs into account when deciding how to proceed.
For instance, if you spent $50,000 on a deck and swimming pool for your house and a buyer offers you only $30,000 above what you paid for the house, you should decide whether to take the offer based on the state of the current housing market, not on the fact that you incurred a $50,000 cost. That $50,000 is sunk, and your costs don’t matter to a buyer who’s using the market to value your house.
Likewise, if an employee makes a mistake that costs you money, your decision whether to fire the employee should be based only on whether you believe that employee will make costly mistakes in the future. While emotionally you may feel the need for retribution, the cost is sunk. And if you believe no mistakes will occur in the future, the only rational course is to retain the employee.
Though, as humans, we are not always rational. Believing that sunk costs should be taken into account when making a decision is called the sunk cost fallacy, a common mistake in decision-making. Ignoring sunk costs has its own problems though, namely, the sunk cost dilemma.
The sunk cost dilemma is when you correctly ignore sunk costs in a series of decisions, but still wind up with a bad result. It occurs in situations where you receive the majority of your benefit after you’ve incurred the majority of your costs, such as with IT or building projects.
When it occurs, the sunk cost dilemma becomes a downward spiral that you can’t get out of. Each decision you make aims to maximize your future returns, but forces you into taking a larger cumulative loss.
The dilemma is easiest to detect when you have a fixed benefit and increasing costs. But it can also occur when you have a variable benefit, such as the sale price of a startup business or renovated house.
You run a consulting business and just signed a contract to build a sales analytics application for $600,000. You research the project and determine it will cost you $200,000 in software and $300,000 in salaries to build, giving you a profit of $100,000. The project will take 6 months.
After the second month, the team runs into integration problems with one of the legacy databases. It takes most of the month to solve the problem, putting you a month behind schedule and adding $50,000 to your costs. Do you cancel the project?
You can cancel, but you’ve already spent $150,000 on salaries and $200,000 on software. That’s a $350,000 loss. If you continue, you can still make $50,000 profit. And ignoring sunk costs, you only have to spend $200,000 more in salaries to get $600,000 in revenue. You decide to continue.
At month five you deliver the first prototype to your client….who hates it. They want major parts revamped. It will take you an extra month, costing you an additional $50,000 in salaries, to make the changes. Sitting down with your finances, you decide whether to continue or cancel again.
You’ve now spent $450,000. It’s never coming back, regardless of whether you continue or cancel the project. As a sunk cost, it’s irrelevant to your decision. Only future costs and revenues matter since your decision affects only the future, not the past. If you cancel, your future costs and revenues are both $0. If you continue, your future revenue is $600,000, but your future costs are only $150,000, a 4x return. You make the fiscally-sound decision to continue.
Two months later, disaster strikes. Your lead programmer breaks both arms mountain biking. You have to hire another programmer to work with him and it’ll take a month to get him up to speed. You’re looking at another $50,000 and another month delay. Is it time to cancel yet, or keep going?
Looking at the numbers, you realize you’ve spent $550,000 so far. If you continue, you only have $100,000 left to spend and then you’ll get $600,000. Even though that would mean a loss of $50,000 for the project as a whole, it still makes sense to spend $100,000 to get $600,000 than to make nothing and have a loss of $550,000 on the books. You decide to continue.
No more problems occur and you deliver three months late for a total cost of $650,000. Your client gives you a check for $600,000 and you take a $50,000 loss. Even though you made rational, forward-looking decisions that ignored sunk costs the entire time, you wound up losing money.
Solving the Dilemma
Once you’ve entered a potential sunk cost dilemma situation, you can’t prevent the dilemma, you can only mitigate the chance of it occurring. Though with proper foresight, you can avoid sunk cost dilemma situations, or if you must enter them, reduce the impact if the dilemma occurs.
Use Incremental Wins
The sunk cost dilemma occurs when you incur your costs before you receive your benefits. To avoid this situation, attempt to structure your projects or investments as incremental wins, sinking your benefits at regular intervals with your costs.
Break your project into phases, earning your benefit at the end of each phase rather than the end of the entire project. Use agile development methodologies to create value earlier, allowing you to gain partial benefit if costs start to overrun. Switch to time-and-materials billing instead of project-based billing. Spend extra time to make code and processes reusable, allowing you to take the benefit in the future.
Increase Your Options
Instead of only two options, continue/cancel or go/no-go, create additional “outs”, options that reduce your costs or risks that you can exercise if needed.
Use optional requirements that can be cut if needed. Build flexibility into your solution so you can pivot into other markets or applications to recoup costs. Create multiple paths forward, calculate costs and risks for each path, then chose the best path. Create alternative benefits like renting until you can sell your house or charging half price for an early release version of your application.
Quantify Costs, Benefits & Risks
Make sure you properly quantify your costs, benefits and risks. Calculate net present value of your costs and benefits if your project takes longer than a couple months. Use three-point estimation in projects to incorporate variance in your projections. Identify key risks and develop a discount rate to use to adjust your costs.
Adjusting your costs based on potential risks becomes particularly important if you find yourself in a sunk cost dilemma situation. A straight financial analysis might favor continuing, but when risk-adjusted, canceling turns out to be the better option.
Mitigate your risks. Increase the frequency of your decision points to identify risks earlier. Buy insurance. Use equity investments to share risk and costs with others. Defer costs until absolutely necessary. Consider spending more to buy in smaller increments or to buy later rather than earlier. Negotiate return policies.
Cut Your Losses
Finally, know when to call it quits. If your risk remains high or your costs overrun even for low-risk tasks, it may be time to take the loss early while it’s still small. Use your experience to guide you and make a judgement call.
For another look at the sunk cost dilemma, read Oliver Lehmann’s The Sunk Cost Dilemma, which includes details on how game theory applies to the dilemma.
Credits: The photo used in this article was taken by Julia Manzerova.