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Sunk costs

One of the less intuitive but sometimes more important concepts we learn in business school is to forget about sunk costs.

Sunk Costs refer to money, time and other resources you spend on a project or  investment. They have been “sunk” into your work and as you’re looking to make new decisions now, you cannot get them back.

Here is the general rule of sunk costs.  When making a choice between two options, you have to forget about sunk costs and instead only consider the future ones. Forget dollars you’ve spent, hours you’ve worked and time you’ve put in. You can’t get them back and they don’t affect today’s decision.  Instead think only about the decision in front of you. Consider the pros and cons. Think about the best return for your money and time now.

Here is the classic example–an investment in your new business.

You’re launching a new company that you hope might be the next big thing. You’ve been funding it out of your own wallet and you’ve been optimistic that it will work out in the end. By now, you’ve spent the past 12 months working hard. You’ve hired multiple employees, contracted a web developer, spent money on bank fees and spent 75+ hours every week trying to turn it into something great. When you add it all up, you’re well over $100K in.  That number, that represents your sunk cost. You’ve spent the time and money and you won’t be seeing that again in your Bank of America Account.

Here’s where it gets interesting.

After all your effort, the project isn’t taking off as quickly as you thought.  Time is more limited. You don’t think you’re getting the right feedback. The website isn’t attracting enough people. And most importantly, the product needs to be updated for your future buyers, or they won’t buy it. And all of this is going to cost you a lot more cash. You think it’s possible to fix it, but that will take another 6 to 12 months to pivot. You’ll also have to hire another person and spend more money on resources. How do you decide? Should you spend the money? And should you consider past costs?

Under the rule of sunk costs, to make the decision to move forward or not,  the money you spent is completely irreleevant. You should only consider the additional cash you will have to spend and the additional value you can create. And if the numbers work out then invest more–if they don’t you pull back.

The same thing holds true in other circumstances too. A project you are leading at work. Time spent trying to win a competition. Time spent trying to woo a customer or a potential significant other.

But it’s all easier said than done. After all, humans are not only tied to their time and money but they also have a tough time forgetting the past. Especially when you’re working hard on something you’re passionate about. When lots of people are looking. And when we think our reputation is on the line.

But conventional business wisdom says you should not include the costs you have already sunk into the project into your decision.

Hard to say that this holds true 100% of the time.  I personally believe deeply in the power of understanding the past.

But definitely something to think about.