The Sunk Cost Fallacy: Is it Affecting Your Business Decisions?

All organisations set out to make rational and effective decisions aimed at maximising their gain and success. However, being led by individuals who can succumb to irrational forms of thinking, organisations can suffer the consequences of irrational decision-making. The sunk cost fallacy is one common form of irrationality that could be affecting your business decisions.

In this article, we will discuss the sunk cost fallacy and the techniques you can use to identify and avoid it in your business.

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What is the Sunk Cost Fallacy?

Simply put, sunk costs are costs that have already been incurred in the past and cannot be recovered in the future. The sunk cost fallacy is a cognitive bias that arises when decisions are heavily influenced by the consideration of these sunk costs. The sunk cost fallacy is driven by the tendency to continue investing in something because of the time, energy or money already spent on it. This leads to irrational decision-making.

This means that someone who has fallen into the sunk cost fallacy is likely to continue working on an initiative, activity or project that may not be profitable or viable merely because they have invested so much already.

The sunk cost fallacy is based on:

• The fear of losing a previous investment
  
• The belief that an initial investment or past success are indicators of future success

The Sunk Cost Fallacy in Business

Many business owners make the mistake of sticking with an idea or initiative that they have already invested in even though there's a high risk of failure or the project will not work out.

In a business setting, decisions based on sunk costs translate to ineffective and unproductive outcomes.

Sunk Cost Fallacy Business Examples:

• Investing in the wrong kind of staff training and development
  
• Maintaining contracts and relationships with certain suppliers even though they may not be meeting current business needs
  
• Running a marketing campaign that has generated negligible results
  
• Purchasing workplace equipment that is likely to become outdated

How to Identify the Sunk Cost Fallacy

It's quite easy to fall into the trap of sunk costs in the business world. Evidently, the sunk cost fallacy is a primary reason why business leaders and entrepreneurs can, at times, fail to jump ship on projects or ideas that are not likely to yield favourable returns.

A great way to know if you and your business are victim to the sunk-cost fallacy is to consider the following set of questions:

Reflecting on these questions is essential to minimising the influence that sunk costs can have on your decision-making.

How to Overcome the Sunk Cost Fallacy in Business

If a business is to be successful, it needs to make effective decisions. For this reason, it's absolutely vital that business owners and leaders keep the sunk cost fallacy in check and take the necessary steps to prevent it from affecting their business decisions and outcomes.

The following tips will help with this:

• Consistently review your strategies and plans
  
• Record your project time and associated expenses so you can effectively monitor the allocation of your resources
  
• Assess the potential risks and gains of proposed activities and projects
  
• Develop alternative options and courses of action
  
• Create plans for minimising losses should failure occur
  
• Curb your emotional attachment to projects and decisions
  
• Establish limits or cut-off points at which you decidedly stop a failing project

The sunk cost fallacy can be highly detrimental to a business' success. The cognitive bias prevents people from seeing the obvious and can stop them from abandoning a sinking ship when all reason indicates otherwise. Business leaders need to be aware of the influence that sunk costs have on their business and work to ensure that their current and future decisions are not determined by past costs.