In the context of business, “sunk costs” are when you’ve spent money already and will not recover it. In other words, you’ve “sunk money into something.”
The problem comes in when you keep spending — even when whatever you’ve invested money in, is no longer a good idea. Yet you keep throwing good money after bad.
This sunk costs situation happens much too often in business. We insist on getting value out of the money we’ve already spent. We become determined NOT to lose money. We can’t — we won’t — let go.
However, by not letting go when something isn’t working, we can end up losing a lot more. We keep pouring money, time and effort into something that has no chance of working or would lead to a poor result at best. The project or initiative keeps costing more and more. Instead of cutting our losses, we compound them by hanging on. We make our losses worse.
It goes against our nature to let go.
It’s called the sunk cost fallacy.
The BBC: An Example of Sunk Cost Fallacy
A perfect example of the sunk cost fallacy came to light just last month, in May of 2013. The BBC revealed it was scrapping — finally — a £100 million technology project. It had dragged on for 5 years. The problem: a stubborn desire on the part of the BBC’s Chief Technology Officer to continue building a custom system when commercial systems already on the market would have done the job at a fraction of the cost. Add to that an overpaid, under-supervised enterprise consulting firm — and you have a sunk cost fallacy of epic proportions.
Instead of calling it quits, the project dragged on. Instead of admitting the money previously spent was sunk costs that would never be recovered, they poured more money into it.
Entrepreneurs and business owners can fall into the same trap. We get emotionally caught up in a project, an employee, an initiative. We want to make it work. We think that somehow we’ll turn things around. After all, it would be wasteful not to try to get benefits out of money we’ve already spent, we think.
We keep pouring money into it in a misguided attempt not to lose our initial investment. We continue long after logic and good sense suggest it’s time to pull the plug.
Pride sometimes is involved, too. Who wants to admit that something was a mistake? ‘Maybe if we keep working on it, we can salvage it,’ we think.
David Ariely, a behavioral economics professor and author of Predictably Irrational, points out that humans often think they will behave in one way (perhaps the way logic and reason suggest). But in reality we behave differently (perhaps driven by emotion to keep throwing good money after bad).
We tend to focus on the money we will lose if we were to walk away. Instead, if we were reasoning through the problem, we would be thinking about what we could gain by scrapping a wasteful situation — and finding a better solution.
How to Avoid a Sunk Costs Nightmare
As entrepreneurs and small business owners, what can we do?
1) Focus on your business goals and the end result you want. In other words, you need to look to the future, not money spent in the past.
Put out of your mind the idea of recovering on sunk costs. The money is gone. Cut your losses. Sweep up the mess … and move on to something more productive.
2) It’s also important to learn to recognize when you might be in the midst of a sunk costs problem. We may not even realize that we are in danger of succumbing to the sunk cost fallacy. When we’re smack in the middle of it, it’s hard to see that we are putting more money at risk.
3) Get a second opinion from someone not emotionally involved in the past expenditures. This is where a good accountant or CFO is worth his or her weight in platinum. He or she will be more likely to evaluate the situation logically.
A smart business owner knows when to seek advice — and take it.
Shutterstock: wasted money
Entrepreneurs need to be great at taking action ( no problem there ) and being honest with themselves ( problem).
I work with a lot of entrepreneurs, and they end up in the sunk cost fallacy for a few reasons:
1. They are emotionally tied to their business
2. They are over confident and believe that with just one more investment, they can make it work
3. They don’t want to admit that this one might have been a bad idea.
Listen guys, the only bad is loosing money. Be an entrepreneur not an emotional train wreck. Get in and get out fast if it’s not going to work. Instead of withering away in a rotting company, get out and use your talents to start something that will create real value for your customers.
Hi Eddy, another option is to shift your business model. Lots of entrepreneurs start out doing one thing and a year later their business is something much different, because they’ve learned what works, what customers want, what they can make money at, and more.
When I was running a troublesome franchise unit, I’ve spend my entire savings – plus borrowing from my parents – just to keep the store running. To say the least, I’ve lost quite an amount of money just to hang on to my “dream business.”
The best decision I’ve made (and I do wish I made it much earlier) is to let the franchisor to take over the store. No more dragging sunk costs.
I feel that knowing when to let go – and actually letting it go – is a skill every entrepreneur should master.
I know that’s a tough decision to make. But like you say, it can be liberating to make that decision.
We all have failures in business — or maybe not a failure, but things that didn’t work out as well as we’d hoped. I have a few of those ideas every year, with new business lines I start. Some are winners, some are so-so, and some are failures.
There’s no shame to it. It just is a fact of life in starting and running your own businesses.