This is from the “Accounting Makes Cents” podcast episode #72 released on Monday, 26 August 2024.
Today’s episode is not necessarily CIMA-centric, but it is a term we should be familiar with if you’ve ever studied the relevant costing, which is a concept used in decision-making, focusing only on the costs and revenues that will change as a result of a specific decision. Now I don’t think I’ve done an episode of everything related to relevant costing, but I remember having a blog post about it, talking about buying a printer. And I do remember an older episode related to opportunity cost. I’ll link these items on the show notes if you wanna check them out.
Jump to show notes.
Anyway, today’s topic as mentioned is not necessarily something we study in detail via CIMA, but it is a fascinating topic that can really make or break your decision-making skills in business, and honestly, in life too. We’re going to be talking about Sunk Cost Fallacy. It probably sounds like some dry economic theory but just stick with me and you’ll see how this sneaky little concept can affect everything from investments to personal projects.
What is it?
Let’s break it down. What is sunk cost fallacy? You must’ve already heard these phrases before.
“We’ve come this far…”
“We can’t let all this effort go to waste.”
“We’re in too deep…”
“It’s too late to back out now.”
“Let’s just finish what we started.”
And my favourite….”We’ve got too much skin in the game”.
Sunk cost fallacy is all about how we, as humans, have a natural tendency to keep investing in something simply because we’ve already put so much into it. Imagine you’ve bought tickets to a concert, but on the day of the event, you’re feeling under the weather. Instead of staying home and resting, you drag yourself to the concert because you don’t want to waste the money you spent on the tickets. Sound familiar? That’s the sunk cost fallacy at work. The rational decision would be to rest up and cut your losses, but because you’ve already invested money into the tickets, it feels like you HAVE to go, even if it’s not the best choice for you. Obviously this is not a good decision. If you’re sick, you shouldn’t be spreading your germs at a concert. But that’s another point.
Now, let’s scale this up and relate it to the business world. This is where things get a bit more interesting, and potentially more expensive than concert tickets. Businesses are constantly making decisions about where to allocate resources, whether that’s money, time or manpower. But here’s the thing, sometimes despite all the signs that a project isn’t working out, companies continue throwing resources at it. Why? Because they’ve already spent so much on it. It’s like they’re caught in a cycle where they just can’t let go.
An example of this is maybe your company had a big, expensive marketing campaign that it launched. Only you find out that this campaign didn’t really resonate with your customers. But instead of pull back on the campaign, the company, you, decide to pump even more money into it, hoping that eventually, it’ll pay off. But in reality, they’re just digging a deeper hole. The rational move would have been to stop, reassess, and maybe even scrap the campaign altogether. But the sunk cost fallacy makes it hard to do that because no one wants to feel like they’ve wasted money or effort.
Why is it important not to get sucked in?
So, why is it important to recognise and pull out of this fallacy? Well, first off, it’s about being smart with your resources. Whether you’re running a small business or a giant corporation, resources are finite. If you’re pouring them into a failing project, you’re not just losing more money, you’re also missing out on opportunities that could be far more successful. Imagine, if instead of clinging to that marketing campaign, the company redirected its budget to a different strategy that actually resonated with customers. The difference could be huge.
Another key reason to watch out for the sunk cost fallacy is that it impacts your decision-making process. When you’re too focused on what you’ve already invested, it clouds your judgment about what the best course of action is moving forward. This can lead to a series of poor decisions that snowball over time, turning a small problem to start with, into a major setback.
And it’s not just about the money. There’s also morale affected. If you’re a leader and you keep pushing a failing project just because of past investments, it can be incredibly demoralising for your team. Imagine working hard on something that everyone knows isn’t going anywhere, but you’re told to keep at it because “we’ve already come this far”. It’s frustrating. It can lead to burnout and a loss of trust in leadership. On the flip side, being able to recognise when to pull the plug can actually boost morale. It shows your team that you’re committed to making smart, forward-thinking decisions, not just stubbornly sticking to a plan that’s clearly not working.
What to do to not fall deep into the fallacy?
So, how do we avoid this, falling deep into the sunk cost fallacy? It starts with awareness. Make it a habit to regularly reassess your projects, and don’t be afraid to ask the tough questions: is this really working? Is there a better use of our resources? What’s the opportunity cost of continuing down this path? Sometimes, the best decision you can make is to cut your losses and move on to something new.
Now, before I wrap up this episode, I want to touch on something important. While we’ve spent a lot of time today talking about the dangers of the sunk cost fallacy and how it can lead you down the wrong path to something that’s not working, there’s also the other side of the argument to consider. It’s the idea of giving up too quickly and using the fallacy as a crutch to justify not seeing things through.
You see, the concept of cutting losses is incredibly powerful, but it shouldn’t be an excuse to abandon projects at the first sign of trouble. In business, persistence and resilience are just as important as knowing when to walk away. Some of the most successful companies out there have faced challenges, setbacks and even failures along the way. But they didn’t just throw in the towel at the first obstacle. They adapted, pivoted, and kept pushing forward.
How do you strike that balance? It’s very strategic. Ask yourself: Is this temporary, or are there fundamental issues with this project? Have I given this project enough time and resources to truly gauge its potential or am reacting too quickly to early difficulties?
Initial failures are just part of the process. With a bit of perseverance, you can turn things around. The key is to be honest with yourself about whether you’re sticking with something because it still has potential, or if you’re just holding on because you’re being sentimental about your past investment. Don’t be afraid to let go. At the same time, don’t let fear of failing or falling into the fallacy prevent you from giving the project the time and effort it needs to succeed.
Show notes simplified
In this episode, MJ the tutor discusses decision-making with a focus on the sunk cost fallacy, a psychological trap that can lead businesses down costly paths. She explores what it is, how it can impact decisions, and why recognising when to cut your losses is crucial for success.
MJ THE TUTOR 