Sunk Costs
Sunk costs refer to expenses that have already been incurred and cannot be recovered. A common management mistake is continuing a project simply to justify the initial investment. However, this approach can lead to further financial losses. Therefore, when deciding whether to continue a project, it is crucial to consider only potential costs and potential benefits. In this way, sunk costs are relevant for assessing the total project costs but should not influence the decision to proceed.
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Sunk Cost Example
Imagine you are developing new software. As the project nears completion, a new technology emerges and eventually that makes your software obsolete. However, you have already spent €3 million on the project and need an additional €1 million to finish it.
At this point, you discover that starting a new software project aligned with the latest technology would cost €2 million and has long-term success potential. The decision now is whether to complete the current project, spending an extra €1 million on an obsolete product, or invest €2 million in a new, future-proof solution.
A good manager should disregard the €3 million already spent and focus on the best financial and strategic decision moving forward. However, many struggle with this concept, leading to inefficient decision-making.
Sunk Cost Fallacy
The sunk cost fallacy stems from the belief that more money should be invested in a project simply because it has already begun. In other words, people continue spending money on a failing project just because they have already invested in it, even when the final outcome is negative.
For example, imagine a company decides to change its name as part of an international expansion strategy. Without conducting proper market research, the company starts rebranding, updating the website, and redesigning stationery. Later, market research reveals that the new name will not work in the target countries. Despite this, the company proceeds with the name change to justify the money already spent, leading to additional unnecessary expenses.
The Importance of Understanding Sunk Costs
Fully understanding the concept of sunk costs is essential for avoiding unnecessary expenses and poor decision-making. The key is to remove emotions from the equation and focus on maximizing investments to ensure the organization’s success. A good manager must ignore the discomfort of losing money already spent and prioritize the company’s long-term well-being.