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Sunk costs: How should they affect your future business decisions?

sunk costsWhether in business or in personal life, we can all look in the past and say that we’ve been in situations where we’ve wasted money, time, or energy on things that did not end up being worthwhile. Was there a moment during that situation when you thought about backing out before you sank even deeper?  The sunk cost dilemma refers to the decision between investing additional resources into an uncertain situation, or abandoning the sunk costs. In this blog, we are answering the question: how should sunk costs affect your future business decisions?

How should sunk costs affect your future business decisions?

There are controversial views whether sunk costs should affect your future business decisions and be considered in the decision-making process. Take sunk costs into account to prevent the mistakes of future sunk costs. But they should not be the main reason why you stay in a downward-spiraling predicament. Humans have the inherent tendency to deny failure. We fear facing defeat. However, by not facing those failures head on, we run the risk of making the same mistakes in the future. Those who say to disregard sunk costs ignore that sunk costs are a critical aspect of improving your business.  Once you learn what NOT to waste resources on and when to walk away, then you can spend resources on profitable and rewarding things.

Example of Sunk Costs

For example, I met a business owner who had spent a significant amount of resources into a new start-up business. Bit it had been falling in a downward spiral for months. He heard of a new business opportunity that could be implemented quickly and proven very profitable.  The business owner asked for my advice. He felt like it was wrong to walk away from the all of the money, time, and energy invested into his business venture.

My first reaction was the following… If his justification for not letting go and moving on to new opportunities was the notion that what he had invested made the venture worth something, then he would acting irrationally and unrealistically.  Although his business may have had some value, the worth of the business would not necessarily improve if he spent even more money, time, or energy into it.  If he decided to stay in his current business solely based on his attachment to the sunk costs, he would lose out on a higher return on his resources with the new business opportunity.

Next time you are in a similar business predicament, be rational and realistic.  Make smart decisions not solely based on your attachment to the resources you have invested until that point in time. Learn from the past mistakes of sunk costs and improve for success in future business opportunities.

Click here to read more about sunk costs. Also, learn how you can be the best wingman with our free How to be a Wingman guide!

sunk costs affect your future business decisions

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sunk costs affect your future business decisions

 

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Sunk Costs

See Also:
Sunk costs: How should they affect your future business decisions?
Variable vs Fixed Cost
Replacement Costs
Joint Costs
Service Department Costs
Ten In-House Secrets for Reducing Your Company’s Legal Costs
Capital Budgeting Methods

Sunk Cost Definition

What is sunk cost? A sunk cost is a cost that has been incurred and cannot be recovered. The money is spent. In accounting, a sunk cost is a type of irrelevant cost. When facing a potential project or investment, a manager must only consider relevant costs and ignore all irrelevant costs.

When a manager is considering a particular decision, relevant costs are the costs that are incurred if the decision is made and irrelevant costs are the costs that are incurred whether or not the decision is made. A sunk cost is not a relevant cost for decision making.

Whether a cost is relevant or irrelevant depends on the decision at hand. A cost may be relevant to one decision and that same cost may be irrelevant to another decision. A sunk cost, however, is always an irrelevant cost.

Sunk Costs Fallacy

The sunk cost fallacy is when someone considers a sunk cost in a decision and subsequently makes a poor decision.

An example of the sunk cost fallacy is paying for a movie ticket, finding out the movie is terrible, and staying to watch anyway just to get your money’s worth. When you find out the movie is terrible, you should make a decision whether to sit through the bad movie or to do something more meaningful with your time – the price you paid for the ticket should not affect your decision. The ticket price is a sunk cost.

Another example of the sunk cost fallacy is paying for an all-you-can-eat buffet, eating until you’re full, and then going back for more just to get your money’s worth. When you are full, you should decide whether you want to eat more or to stop eating – the fact that you paid for unlimited food should not affect your decision. The price of the buffet is a sunk cost.

Sunk Costs Examples

Let’s say a company spent $5 million building an airplane. Before the plane is complete, the managers learn that it is obsolete and no airline will buy it. The market has evolved and now the airlines want a different type of plane.

The company can finish the obsolete plane for another $1 million, or it can start over and build the new type of plane for $3 million. What should the managers decide? Should they spend that last $1 million to finish up the plane that’s almost done, or should they spend the $3 million to build the new plane?

At first glance, you may think the company should just finish the old plane. It’s only another million bucks and they already spent $5 million. But in reality, the five million is irrelevant. It is a sunk cost. The only relevant cost is the $3 million dollars. The managers should consider whether or not to spend $3 million on the new plane, and nothing regarding the old plane should affect the decision.

sunk costs

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