You shouldn’t avoid hiring a better trained and dedicated IT person just because your office staff took one computer course. On a psychological level though, you might believe if you don’t go you won’t get your money’s worth. The best way to illustrate this concept is with an example that has played out many times over the past several years. You’re a homebuilder during the bubble and you’ve started work on 20 spec homes in a small development.
The term “Concorde fallacy” is derived from the Concorde jet project between Britain and France. Despite its evident unprofitability as the project progressed, both nations continued to fund it because of the significant amounts already invested. Essentially, they tried to justify past expenses by investing further, even when the outcome looked bleak. The main difference is that sunk costs are not considered when making future decisions, while relevant cost is significant in the decision-making process and can be changed. It is a type of cognitive bias arising from people’s tendency to get emotionally attached to their investments.
Irrational Decision-Making
Still, after a few months, the ERP system was found unreliable and unproductive due to changes in office culture. The company wanted to replace the ERP system and had to train its employees again to use a new ERP system. In the first case, the training expenses of $10,000 would be considered a sunk cost as it was an expense that would not be recovered in the future and not at all useful in any future business activity.
Opportunity cost is the benefit lost when you choose one course of action against another. Key characteristics of sunk costs include having occurred in the past, and being irreversible and unrecoverable. This is the psychological concept of continuing with poor investments to avoid the perceived shame of wasting money, resources, and time. People usually want to avoid being negatively viewed by their professional network, peers, and family as unintentionally wasting resources, including capital. A small business leadership team choosing to continue sunk costs is a reflection of poor financial and business judgment. It’s important to reflect on the type, the amount, and the duration of sunk costs.
In this example, the architecture fees are an example of a sunk cost. But if you want to use the Sunk Cost fallacy to your advantage, sign up for a challenge, a class, or an event before you go. Reserve a spot at every Thursday evening yoga class for the next month. Once you take this step, you are much more likely to follow through. The cost doesn’t even have to be something that came out of your pocket. A study asked participants to imagine that they were full after eating some cake.
- To calculate a sunk cost, you simply subtract the amount of money you’ve spent from the total amount of money you had available to spend.
- These costs must always be weighed against the potential revenue expected to come from the decision (Broadbent & Cullen, 2014).
- For example, a company may ignore market shifts that render their product obsolete.
- Have you ever been unable to stop a project simply because you’ve already invested so much?
- It is always advisable to avoid focusing on the sunk cost that may adversely affect future choices.
Because you can’t get the $500 back regardless of whether or not you hire an IT person, it’s a sunk cost and shouldn’t affect your future staff training decisions. For example, a company invests heavily in a product even when market research shows a decline in demand simply because they have already put so much effort into it. This tendency to stick with a failing project due to past investments is a trap that many individuals and businesses fall into. This type of thinking should lead to the choice that provides the greatest net additional benefits, regardless of what has happened in the past.
What Is Irrational Decision-Making in the Context of Sunk Costs?
Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision. Sunk cost is also known as unrecoverable cost as the amount that cannot be recovered, which has already been spent on some business activities. For example of sunk cost example, almost all businesses spend on marketing and advertisement to promote their products and services. The amount which has already been spent on marketing and advertising cannot be recoverable. So, advertising and marketing expenses should not be considered in the decision-making process. In business, it is important to understand the concept of sunk costs to make informed decisions.
Is the Sunk Cost Dilemma Common in Business Decisions?
A ticket buyer who purchases a ticket in advance to an event they eventually turn out not to enjoy makes a semi-public commitment to watching it. To leave early is to make this lapse of judgment manifest to strangers, an appearance they might otherwise choose to avoid. As well, the person may not want to leave the event because they have already paid, so they may feel that leaving would waste their expenditure. Alternatively, they may take a sense of pride in having recognised the opportunity cost of the alternative use of time. For example, business owners may believe they have a good chance of success if they invest their finances in a particular venture, despite a similar venture failing in the past. A business owner may also assume that significant capital increases their return on investments.
This period is known as the retrievable cost because you still have time the retrieve your money from the store. If you’ve passed that period—some may give you as many as 90 days to get a refund—then you may not be able to get a refund, resulting in a sunk cost. Yes, any salary that has been paid to an employee is a sunk cost. As long as those wages are not recoverable, that salary represents an expense that has been incurred and can not be captured back by the company.
It can still be tempting to invest in a plan that’s no longer working because you want to make the lost money feel worthwhile, and that urge is the sunk cost fallacy. Before you make a decision to keep going with one plan, ask yourself, “What opportunities am I giving up if I keep investing in the current course of action? ” This way, you can avoid dwelling on past costs and instead focus on the potential of other opportunities you might miss out on if you keep defending your current strategy. Loss aversion is a cognitive bias where people feel losses more intensely than gains.