Let’s say you spent $1M on a project the vendor says they need another $100K to complete it. Even if completing the project will not produce $100K of value – do you do it or not? What if it only needed $10K? The answer may surprise you and depend on your understanding of the sunk cost fallacy.
What is Sunk Costs
Sunk costs are costs (money, time, effort) that are not recoverable. Sunk cost represents money you already spent and have no chance of getting back, regardless of what may happen in the future.
Examples of Sunk Cost
The money for my gym membership has been spent, sunk, and I have no way of recovering it regardless of how much value I might get from using it. The cost of software that cannot be sold is an example of sunk cost.
By comparison, some of the cost of a car is recoverable because you can sell it making the difference between the purchase price and the sales price your sunk cost.
Sunk Cost Bias
Sunk cost bias is fascinating and something that has been studied extensively in business decision making. The sunk cost bias is often referred to as the sunk cost error with several distinct characteristics affecting rational choice decision making:
- People have an intense inability to acknowledge our own errors, even to ourselves.
- People become overly optimistic of the outcomes following an investment decision.
- People responsible for an investment decision are affected more by sunk cost.
- People have a bias for continuity that interferes with decisions based solely on the present.
Each of these characteristics of the sunk cost thinking is a form of irrationality. What makes them irrational is they fail to realize the past is the past and the previous decision is irrelevant in the decision making required in the present.
Like a person that just spent $15 dollars for a movie ticket and knows within the first ten minutes they hate the film still suffers through the entire movie instead of leaving. Or the investor that buys $1000 of a stock and rides it down to $650 instead of selling.
Sunk Cost Fallacy
The sunk cost fallacy, or sunk cost trap, is about people who seek consistency only to become trapped by a prior decision. In this way the sunk cost trap represents people continuing an activity because it is consistent with having started it. Some use the shorthand of the status quo or decision making by inertia.
Another way of describing the sunk cost trap is that people who have made a sacrifice in order to achieve something tend to go on doing it even when they are faced with the prospect of losing more than they will gain by continuing it. Meaning the downside is greater than the upside.
The sunk cost bias can be even be quite amplified when the sacrifice is deemed to be significant. An extreme example of the sunk cost bias is when a government continues or escalates a war so that the lives already lost were not in vein.
In IT we see this all too often in black swan projects, bad technology investments, products that no longer meet the need and vendors that are not delivering. We often refer to this as throwing bad money after good.
You can recognize the sunk cost trap anytime the decision making process focuses on the past with statements like, “we have invested too much already to pull the plug now.”
IT Sunk Cost Economics
The sunk cost economics can be huge in IT because of the amount of labor and intellectual property involved in IT solutions. This is also why sunk cost economics in IT scale quickly giving us sensational headlines.
We have all heard of multimillion dollar failed ERP implementations or failed IT outsourcing deals in higher education. So why do some institutions have the wisdom to pull the plug while others get caught in the sunk cost trap and double down?
We have also heard some pretty awful stories of existing ERP or LMS solutions not keeping pace with current and projected future needs only to have the college double down with more product and long term contracts.
Some go so far as to switch to managed hosting or even paying for a re-implementation. That’s sunk cost bias on a grand scale.
Avoiding the Sunk Cost Trap
The single most powerful way to avoid the sunk cost trap and the effects of sunk cost bias is to establish a formal IT governance model. By using a standardized method for selecting IT investments for funding that factor for risk and likelihood of success, and using a financial analysis using ROI, NPV and IRR.
This way there is no room to introduce the sunk cost that have already been spent into the decision making equation requiring only that you ensure the investment performs.
Then you only have to deal with the human side of the people who made the earlier decision by leveraging your relationship with them and the trust you have built up over time.