Don’t Let Sunk Costs Sink Your Business

cfadeluxeImagine for a second that you really LOVE a good Chick-fil-A sandwich, but the nearest Chick-fil-A is 30 miles away.  The distance, while not enjoyable is no barrier for you.  You pack up the kids, load the car, and set off on your journey to bite into the Spicy Deluxe. 15 miles in, you come to an awful realization: It’s Sunday, so Chick-fil-A is closed for the day!  You curse your luck, or your forgetfulness, or maybe their policy.  But then, you realize that you’ve already driven 15 miles, so you might as well just drive the remaining 15 miles to get to Chick-fil-A.  After all, you wouldn’t want to waste the distance you’ve already traveled.

Sound crazy?  It is.  It’s the Sunk Cost Fallacy.  And, while you might think you’d never do anything so stupid, I’m here to suggest that you probably are and it is probably hurting you.

 

Let’s start with a definition:

Sunk cost refers to costs (whether money, time, etc) that have already been incurred and cannot be recovered.

 

Since these are expenses that, by definition, have already been paid out and cannot be reclaimed, they are irrelevant for future decision making.  Or, more accurately, they should be irrelevant.

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Whenever you make a decision going forward that is based on sunk costs, rather than what is logically best, you have committed the Sunk Cost Fallacy.  People do this naturally, because we are pain-avoiding creatures.  We don’t want to admit that we wasted or lost anything that we’ve invested, so we will make irrational decisions rather than accept reality.  So,  lets look at some real life examples that might hit a little closer to home than driving 15 extra miles to visit a restaurant you know is closed.

stockworryIf a fast-talking stock broker calls you with a hot tip for a stock at $45 that is projected to go to $100, and you decide to buy, what happens when a week later you realize that you’ve been swindled?  The stock is down to $40, your financial adviser is suggesting you sell immediately, and your fast-talking broker is spending his commissions in Aruba.  What do you do?  If you think, for even a second, of trying to “get even” (that is, wait and hope the stock bounces back to $45 so you can sell and break even on the transaction) then you are falling prey to the Sunk Cost Fallacy.  The only decision you should be making is whether that stock is a good investment at $40.  If the answer is no (like your trusted adviser says), then the only reasonable decision is to immediately sell.

 

What if you pick up a novel to read for enjoyment.  After 30 pages you’re bored.  After 65 you’re trying to figure out what slot it will take up on your Top 10 most hated books list.  After page 100 you’re almost in pain.  What do you do?  If you’re like most people, then you don’t read books so you don’t know what I’m talking about.  Wait, wait, wait; that’s not what I meant to say.  If you’re like most people, then the fact that you have invested the time, energy, and expense will influence your decision making.  In reality, you should only be asking yourself if this more likely to bring you enjoyment that something else.  If another book, or another hobby, would be more enjoyable, then you should do that instead.

 

baddateWhat about your 17 year old daughter.  She’s been dating a boy for almost 2 years.  It started off with sunshine and butterflies, but appears to be carrying on out of pure momentum.  She lights up in social settings without him, but merely exists as a shadow of her true self when he is around.  On a particularly open day, you ask her if knowing everything that she knows, whether she would choose to start dating Robbie today.  She says no.  You want to hold back, but you can’t, and you blurt out, “So why do you stay with him?”  She begins to explain that she’s already invested 20 months into the relationship, and they have lots of memories together, and besides, she can’t possibly end it because she already bought his birthday present. All of this is sunk cost fallacious thinking.

 

I could go on, but this isn’t the self-help hour.  This is FBAMaster.  How is sunk cost hurting your business?

 

sunkcostThe easiest example is when people make purchasing decisions that turn out to be incorrect.  We’ve all done it. Maybe you made a mistake or maybe the market just changed, but, for whatever reason, you’re stuck with a product that you can’t hope to sell for a profit. Assuming you can’t get it back and return it to your supplier, you have limited options.  You can let it sit in your inventory, month after month, collecting dust, incurring storage fees, and contributing nothing to your business.  Believe it or not, this is the option that a lot of people will choose. Rather than “take a loss” by selling the product, they irrationally cling to a hope that maybe someday in the future the price will go back up.  Much better is to accept the loss and turn that inventory into money that can be reinvested in your business. (Don’t misunderstand me: there are times where it is proper to hold out, but you should have good, logical reasons for holding out, that are NOT based on your purchase price and NOT based on avoiding loss.  If you’d hold out if you paid half as much, then keep holding out.  But if there aren’t logical reasons for holding out, then you need to sell, not hope.)

What are some other scenarios?  Maybe you paid for a monthly subscription to a repricer that has no refunds.  After a few days, you realize that you didn’t get what you thought you were paying for.  If anything, this repricer is costing you money.  It’s selling for lower than you anticipated.  Maybe you’re spending more time with the repricer than you’d ever spend just setting prices.  Maybe you made a bad decision.  Some percentage of you will continue to use this software for the rest of the month, simply because you paid for it. You must force yourself to stop doing this.  The money you paid is gone.  It’s not coming back to you.  All that matters is whether the repricer is A) Making you money or B) Saving you time.  If it isn’t doing either, then continuing to use it is illogical and you have to stop.

 

Another, you say?  Maybe you’re getting into Private Labeling.  You just paid somebody $99 to design you a slick logo that you plan to use in multiple marketing channels. Your designer emails you the logo, you send her payment, and she disappears.  A few days later, the logo doesn’t look as good to you.  You talk to some friends and family, and they aren’t impressed. You run some tests and you find that your customers don’t like it.  All in all, you wouldn’t use this logo if someone gave it to you for free!  And yet, you paid for it.  Do you keep using it, simply because you already paid for it?  If so, well, then you know what you’re doing.

decisionmakingThere are so many areas where this pernicious little thinking error creeps into our lives and businesses.  I can’t possibly hope to cover every scenario where it might be affecting you, but I hope that by bringing it to the forefront of your mind and challenging you to stop, that you will start to spot areas in your life where you’re being harmed by the sunk cost fallacy.    Please, don’t let sunk costs sink you.

 

As Always, Best Wishes

Mike

9 thoughts on “Don’t Let Sunk Costs Sink Your Business

  • August 14, 2015 at 9:36 am
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    It’s as good a post as I expected, Mike! And I’m still laughing over this:

    “If you’re like most people, then you don’t read books so you don’t know what I’m talking about. Wait, wait, wait; that’s not what I meant to say.”

    Hahaha! Oh, yes it is 🙂

    Reply
  • August 14, 2015 at 10:15 am
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    You are right! I’m sure almost all of us has done that sometime.

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  • August 14, 2015 at 9:12 pm
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    This was great. Such an easy, interesting and eye-opening read!

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  • August 15, 2015 at 8:41 pm
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    Excellent post Mike, thanks for this timely reminder!

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  • August 16, 2015 at 8:20 pm
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    We often are informed of the sales side of the marketing transaction. It, and information on it, are much more shiney, appealing, and easier to sell. No one WANTS to hear about the errors they’ve made and their fallible logic used to arrive at their decisions, but they do NEED to learn about them. This is the dark side of commerce that is often overlooked and seldom understood, as you point out. There is a great book that I often reference by Robert Cialdini, “Influence, Science and Practice”. It weaves a tale of the Psychology of marketing, but neglects to speak of the purchase side of the equation. This is a great book about MARKETING, not Commerce. We could all benefit from an education in commerce, balancing both sides of the commerce scale. Just like Marketing, Acquisitions has an entire horde of psychological demons to exorcise before we can nurture the logical methodology to which you refer. It will take great diligence, but breaking our natural habits as you mentioned is possible and will lead to greater profits as a result. Mostly, keep in mind NET not gross, a fine point often overlooked by beginners, including all the hidden costs such as labor, travel, timing, and research. By timing, I mean that it may be better to enter a hot market with a product that has a smaller margin, than to continue your research for better margins before entering. At least you would attain some market share in the interim.

    All in all, fantastic points to get us thinking and making changes. Thank you.

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  • May 13, 2016 at 12:44 am
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    Humorous examples of the of sunk-cost dilemma, Mike.

    This seems somehow related to “Rich Dad, Poor Dad” and the liability vs. asset argument. The wealthy and successful buy more than their share of true assets — which pay them back in spades. They quickly bail out of bum deals. If they keep a superficial “loser,” it’s because they can endure a longer time-horizon for profitmaking, also a function of their wealth and rational thinking.

    The rest of the unwashed masses (consumers) buy mostly liabilities, or wasting assets — which bring only temporary gratification. And when they run out of the transient pleasure, they look around to buy some more…

    Reply

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