Oct 23

Comments Off on The Sunk Cost Fallacy: How It Affects Your Decisions

At certain points along a timeline, the company could have made more rational decisions; instead, it may now have invested funds it cannot recover and potentially not benefit from in the future. The homeowner can’t necessarily discount the sunk costs, which tends to be a rational thought process. But if he chooses to overlook the sunk costs, he falls into the sunk cost trap or the sunk cost fallacy. This happens when he makes an irrational decision, one made without considering the money he’s already spent. All businesses incur sunk costs, whether these are employees on a payroll or general capital expenditures, such as facilities, marketing, or equipment.

The cost of the building and its depreciation will be the same regardless of the composition of the company’s product mix.
All sunk costs are fixed costs but not all fixed costs are sunk costs.
A real-world historical example of the sunk cost dilemma can be found in the construction of the Sydney Opera House in Australia.
Just because a strategy worked in the past, it doesn’t mean it will work in the future since markets evolve.
However, many managers continue investing in projects because of the sheer size of the amounts already invested in prior periods.

Let’s take a look at how the Sunk Cost Dilemma works and how it relates to rational thinking. The dilemma comes into effect when you consider the money you’ve already spent, as well as money that will be spent in the future. It’s not financially prudent to walk away from something because of the money you’ve put into the decision, but you also can’t walk away because doing so will cost you more money as well.

What is an example of a sunk cost?

It has since become an iconic symbol of Australia and a thriving cultural and economic hub. Some may say decision-makers succumbed to the sunk cost dilemma, though one could argue continue with the project was ultimately the correct move. Persisting with a project, even when it’s evident that the likelihood of success is low, because of the emotional attachment to past efforts is a downfall of the sunk cost dilemma. These key components include emotions, decision-making, and opportunity cost.

For example, purchasing a machine to manufacture goods is a sunk cost because the business cannot resell the machine to recover the full cost of purchasing it. 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.

How to Avoid Sunk Cost Fallacy

Even large entities—such as governments, companies, and sports teams—are susceptible to the sunk cost fallacy. For example, they may continue to allocate more resources discover more about cause branding vs cause marketing into projects, products, strategies, or programs that aren’t profitable or successful. The sunk cost fallacy arises when decision-making takes into account sunk costs.

Example of Sunk Cost Dilemma

Focus on what you can change instead and look at what new costs could be incurred based on any available alternatives and calculate the marginal benefits related to each. Sunk costs should be excluded from such considerations given, no matter what alternative is considered, they will not change. It can be really challenging to walk away from a situation where you’ve already spent any amount of time, money, or energy.

Embrace change

So, payroll taxes, federal unemployment (FUTA), and state unemployment (SUTA) taxes are all sunk costs, too. When presenting analysis of all options and recommendations to the Board, the Project Manager can be clear that 1,300k cannot be recovered and must be accepted as sunk even if the project is terminated. The Board can then consider whether to approve additional investment to avoid the investment being a waste and consider the new amount required to realise the updated project benefits.

This consideration creates a bias in the decision making process which could result in greater consequences rather than the intended benefit which is called the ‘sunk cost fallacy’. In this example the Project Manager will exclude the 800k already spent (the ‘bygones) and also the 300k of future fixed costs which cannot be recovered no matter what happens. This leaves 700k of variable costs which could be changed by decisions such as reducing resources on the project, reducing scope, lowering quality or any other number of project alternatives. Sunk costs don’t only apply to businesses as individual consumers can incur sunk costs as well. Let’s say you buy a theater ticket for $50 but at the last minute can’t attend.

What Is Sunk Cost?

The sunk cost fallacy is a cognitive bias that makes you feel as if you should continue pouring money, time, or effort into a situation since you’ve already “sunk” so much into it already. This perceived sunk cost makes it difficult to walk away from the situation since you don’t want to see your resources wasted. To make this decision, the firm compares the $15 additional cost with the $20 added revenue and decides to make the premium glove in order to earn $5 more in profit. The cost of the factory lease and machinery are both sunk costs and are not part of the decision-making process. Imagine a non-financial example of a college student trying to determine their major.