🖊 This article was last updated on June 12, 2019
Being an entrepreneur is a risky business. By definition, entrepreneurs take on financial risk in the hope of profit. Success or failure is dependent on decisions made, decisions which should be based on facts, figures, intelligence, and intuition.
But so many entrepreneurs base their decisions on sunk costs, believing that past costs matter to future outcomes. What they have fallen for is the ‘sunk cost fallacy’.
We’ll explore what sunk costs are and how their little lies may be sinking your business without you even knowing it.
What is a Sunk Cost?
First of all, every entrepreneur experiences sunk costs. A sunk cost is a fixed cost, something paid for in the past that cannot be recovered by any means. It not only refers to monetary costs, but also to time spent— a currency of sorts, which can also not be recovered. Sunk costs are a part of everyday business life.
For example, a laptop or new software for your solo graphic design business could be considered as sunk costs. Another example could be the time spent chasing and landing a client. It takes effort, brain power, tact and skill, resources spent to achieve something, and they can not be regained. These are costs, monetary, mental, emotional and physical that have been made, are now gone, and more importantly, have no bearing on your business’ future.
When sunk costs become an issue
Decision making is an integral part of business and entrepreneurs spend much of their time considering relevant costs when planning their next move. Future costs and possible future revenue of different opportunities are weighed up and compared. And sunk costs should not be part of that process.
Future costs are changeable and dependant on your decision. Sunk costs, on the other hand, are fixed and no matter your decision, they will not and cannot change.
So, when it comes to a decision in the ‘here and now’ about the ‘there and then’, sunk costs have no business being part of your business decisions!
Yet, somehow they have a sneaky way of creeping in…
Let’s look at an example of sunk costs:
Jane Doe quits her corporate job to pursue her lifelong passion: freelancing as a digital nomad. Because social media is all the rage these days and because she’s on Instagram all day anyway, she decides to become a Social Media Strategist. She takes 4 courses on social media and buys a subscription for 2 premium software products that will help her and her future clients to do her work.
However, she soon realizes that she’s competing with either a bunch of 16-year olds that understand social media better than her, or with huge agencies who can afford to spend hundreds of thousands of dollars on ads.
She’s slowly realizing that there’s no market fit. Deep down she knows she should pivot into a new direction, but because she invested half of her savings into these social media courses and tools, and invested so much of her time, she’s hesitant to switch her career.
She is faced with two choices: pivot and take a new direction, one which would be more profitable and sustainable for her future. Or, keep trying to carve a place for herself in a saturated market, in which she know she won’t survive.
Say for argument’s sake that Jane thinks to herself, ‘I can’t give up. It would such a waste of time and money. I have to keep going to make that spend worth it.”
Then, poor Jane Doe is a victim of Sunk Cost Fallacy.
What is Sunk Cost Fallacy?
The Cambridge Dictionary gives the definition of Sunk Cost Fallacy as:
“the idea that a company or organization is more likely to continue with a project if they have already invested a lot of money, time, or effort in it, even when continuing is not the best thing to do”
Or in layman’s terms, “I’ve come this far, I might as well keep going.”
In our above example, it’s not that Jane Doe is a bad businessperson as such, she’s just stuck in the Sunk Cost Fallacy mindset and feels the natural need to follow through and chase her sunk costs. She’s not the only one that has fallen into this mindset trap.
The Sunk Cost Fallacy mindset
There are psychological reasons for our desire to ‘honour’ sunk costs. The sunk cost fallacy is like the ultimate attempt to save face.
When we succumb to the sunk cost fallacy mindset we justify our past actions when faced with evidence that proves them to be bad choices. But we don’t stop there…
We keep up the charade by refusing to acknowledge failure and actually commit further to our bad idea hoping (or believing) that things will turn around and it will all be worth it in the end. But, it rarely is.
This cognitive bias is what Daniel Kahneman explores in his economical psychology book, ‘Thinking, Fast and Slow’. It’s a belief in an illusion in order to validate what we have already done.
Sunk Cost Fallacy is everywhere!
Sunk Cost Fallacy affects us in every part of our lives, personal and professional. From refusing to throw out the shoes that hurt your feet, just because they were expensive, to staying in a bad relationship just because you’ve been together for 15 years already.
The same is true for staying with toxic clients, even when we know they are bad for business, we may feel ‘attached’ because of the time, money and effort we spent signing them in the first place.
We seem to be hardwired to not want to ‘give up’. The myth that ‘winners never quit and quitters never win’ is deeply embedded in our culture, in society, and very much in our professional lives. But, this refusal to quit does more harm than good, especially when it comes to your business.
The Sunk Cost Fallacy is fed by our innate fear of failure, yet leads us to that very fate. In the business world, Sunk Cost Fallacy is also referred to as ‘throwing good money after bad’.
It’s like digging a hole in search of treasure, then finding the map and realising you’re in the wrong spot… but continuing to dig harder and faster!
How to avoid the Sunk Cost Fallacy trap
Overcoming the sunk cost fallacy mindset is all about making better decisions. I know, easier said than done! But the first step is to give your decision making process more time, care, and attention.
Think about what factors you are taking into consideration. Ask yourself: Am I looking at the bigger picture, to the future? Am I being rational? Or do I feel obligated because I have poured a lot of time and money into the project already?
Being self-aware and honest with yourself is essential to avoiding the sunk cost fallacy. Practicing mindfulness can help with that process.
We have to accept that we are emotional beings and our decisions will be tainted by those emotions. The more we invest in something (time, money, blood, sweat and/or tears!) then the harder it is to let go. Learning to overcome the fear of letting go, this fear of ‘failure’, and acknowledge these fears as irrational is what will set you free from the grip of Sunk Cost Fallacy!
Use Sunk Cost Fallacy to your advantage
When we know we are naturally prone to chasing a sunk cost then we can capitalise on it! For example, when you want to learn a new skill, buy a course instead of watching free videos.
Investing the money will make you more committed and you’re more likely to pay attention, complete the course, and implement what you learn. This in turn makes the course more valuable and a sensible investment.
Being able to recognise your sunk costs for what they are and cut them loose will save you time, money, ad effort, and save your sanity! Decisions based on critical thinking and some soul searching will set your business in good stead.
Remember that a business based on backward-looking decisions cannot move forward.