Focusing on sunk costs will sink you

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You just spent $10,000 on a website redesign. You tested it with several non-industry friends, and some of your family (who look like your customers) and they uniformly don’t like it. They liked a comparison site that you showed them—from someone that runs a similar company across the country. Your designer says the changes you want to make will cost you $2,000. It would cost you $2,000 to dump the redesign and go with something very similar to the other company’s from the same vendor they used (you wish you would have picked them first) that will give you even better functionality, a better content management system, and better integration with your customer database. What do you do?

Research suggests that you’ll probably stick with the disaster that you’ve just spent the $10,000 on. And that is likely not the best thing you could do. For the same $2,000, you could get something better by abandoning the bad effort and going with the new vendor. That would likely be the better choice.

There’s a good chance you’ve been a victim of the sunk cost fallacy. Almost all of us are from time to time.

Sunk costs, whether dollars or blood, sweat, and tears, are costs that have been paid already and that you cannot get back. The money or time have already been spent.

And thus you should completely ignore them. Once the resource has been spent, your question should be, “what is the best way forward today?” Yes, often times the best way is to build on your initial investment and keep pushing forward. But other times, it makes sense to completely abandon the effort. With the latter, most of us struggle.

I just reread a paper I wrote in grad school days. It reminded me of the Kahneman and Tversky experiment that first pulled my attention to the area of behavioral economics.1,2

Going further, Arkes and Blumer conducted a few experiments in 1985 which really showed our tendency to make different decisions based on sunk costs. In one they asked subjects to assume they had spent $100 on a ticket for a ski trip in Michigan. Several weeks later they bought more tickets for a trip they though like even better. Only after buying them did they discover the two (non-refundable) trips overlapped. They had to choose which trip they would take.3

54% of the people said they’d go with the more expensive trip, even though they’d enjoy it less. The money is already spent for both. You can’t get it back. Choose the one you think is better!

We hate to lose stuff, and we make bad decisions to avoid losing stuff, even if it means missing out on something better!

Next time you’re evaluating a marketing campaign, a new product line that you’ve invested in, or a training program that you’ve just spent a lot on but that someone else can deliver to your staff better for less, try hard to ask yourself given where I am today—and ignoring what I’ve already spent—what’s the best way forward?

Cheers,
Mike

1The paper, The Framing of Decisions and the Psychology of Choice by Kahneman and Tversky is well worth a read in its entirety. The experiment I’m referring to included these questions for different subjects:

First Case: “Imagine that you have decided to see a play where admission is $10 per ticket. As you enter the theater you discover that you have lost a $10 bills. Would you still pay $10 for a ticket for the play?” 88 percent said yes, and 12 percent said no.

Second Case: “Imagine that you have decided to see a play and paid the admission price of $10 per ticket. As you enter the theater you discover that you have lost the ticket. The seat was not marked and the ticket cannot be recovered. Would you pay $10 for another ticket?” 46 percent said yes, and 54 percent said no.

Economically, these are exactly the same decision. Will you pay $10 to enter the theater now? The only difference is what you did before, buy (and lose) a ticket, or lose some cash. Rational people would make the decision purely on whether it was worth shelling out the $10 to see the play. But we’re just not as purely rational as we think.

2Thanks, Mom, for sending that box of treasure from your basement. Is my beer can collection still hiding down there somewhere?

3Of course, the obvious flaw with this experiment is focusing on skiing in Michigan and Wisconsin instead of places with bigger mountains and lots of snow. Or lots of ice if you want to get the technical chops of my Vermont compatriots. Don’t let that stop you from reading their paper, The Psychology of Sunk Cost, though.

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About the Author:

Mike Rogers is the President of OmStout Consulting. A nationally recognized expert in residential energy-efficiency, he works with contractors and programs to scale sustainable market approaches to improving homes. More on Google+

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