Sunk cost is an economic concept that refers to costs that have already been incurred and cannot be recovered. These costs should not influence future investment decisions, as only profit or loss expectations matter. However, many times decision makers are driven by loss aversion and continue to invest in projects that are not profitable, just to avoid admitting failure or to avoid wasting the money spent without realizing that even more money is being wasted. It is quite common to see how companies are tempted to continue investing in projects or assets simply because they have already dedicated resources to them, ignoring that these costs are already incurred and should not be considered when evaluating new opportunities.
This irrational behavior can have negative consequences for companies, especially for senior management, who must manage resources efficiently and strategically. Some examples of sunk costs that we can find in organizations could be:
This irrational behavior can have negative consequences for companies, especially for senior management, who must manage resources efficiently and strategically. Some examples of sunk costs that we can find in organizations could be:
- Obsolete or ineffective software: If a company has invested a large amount of money in the installation of business management software that does not meet expectations or has become outdated, the cost of the installation is a sunk cost. There is no point in continuing to use that software just because you paid for it, if there are other more suitable or cost-effective options on the market. What the responsible person can do, is to evaluate the available alternatives and choose the one that best suits the company’s needs and objectives, regardless of the money spent in the past.
- Unnecessary equipment or infrastructure: Another example of sunk cost is equipment or infrastructure that has been purchased or built for a project that was later cancelled or modified. For example, if a company has purchased servers or rented space to host them, but then decides to migrate to the cloud, the cost of the servers or rent is a sunk cost. There is no point in keeping those resources if they are not going to be used or if there are cheaper or more efficient options. What the CIO must do is analyze the cost-benefit of each option and opt for the one that maximizes value for the company, regardless of the money lost in the past.
- Failed or nonviable projects: A final example of sunk cost is that of projects that have been started with an initial investment, but have later proved to be unsuccessful or nonviable. For example, if a company has invested in the development of a mobile application that has not been well received or has technical problems, the development cost is a sunk cost. It makes no sense to continue investing in that project just to try to recoup the money spent, if there are other more promising or profitable business opportunities. Once again, the best thing to do is to evaluate the potential of each project and prioritize those that bring the most value to the company, without getting carried away by pride or attachment to the past.
As we can see, sunk cost value is a key concept for decision-makers in the company. These decisions must be rational and well-informed. To avoid falling into the sunk cost fallacy, it is good:
- Separate sunk costs from future or variable costs, and focus only on the latter when evaluating investment options.
- Take into account the opportunity cost, i.e., what is not gained by choosing one option over another.
- Accept past mistakes or failures and learn from them, without letting them affect present or future decisions.
- Seek objective and contrasted information, and consult with experts or colleagues, to avoid biases or personal prejudices.
- Establish clear and measurable objectives, and periodically review the performance and impact of the investments made.
Proper understanding of sunk cost can have a significant impact on business management. By recognizing that past expenses should not influence present decisions, companies can focus on maximizing future value and optimizing their resources more effectively. This can lead to greater business agility, better resource allocation and higher long-term profitability.