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This article appeared in March 2018, in Romanian, in BIZ Magazine

Why do we continue a bankrupt project just because we have already invested a lot of money, time, effort or feelings in it?  The trap of sunk costs is extremely common, with various damages.

Did it happen to you to buy a pizza and, after eating a half, to realize that you had enough, but you want to finish it just because you paid for it? Or to stay in a job you hate or in a toxic relationship just because you’ve been in it for 10 years already?

To create a product or a service that is no longer needed, but you keep spending money, time and effort on another features, hoping that maybe you can rescue it? This thing is known as “throwing good money after bad” and economists call it “sunk cost effect”. We continue a bankrupt project just because we have already invested a lot of money, time, effort or feelings in it. And we do that because we hate losing or wasting things.

The problem is that, sometimes, the effect is so strong that people are immune to any explanation, mathematical, financial or otherwise. Let’s take a small example that I use in class: you are the local manager of a telephone company and you see that, in the city center, the competition has just opened a flagship store.

You don’t think long and start setting up an even bigger store, which costs a lot of money which you won’t be able to take back (no one could reuse that custom design). After a few years in which the store constantly loses money and doesn’t even help the brand, a new employee asks you why you don’t close it. And the answer is: “How could I close it? Do you know how much the initial investment was?!”.

But we can’t take the initial investment back, it’s irrecoverable in both scenarios (I close / hold it), so it doesn’t matter! The things that matter are incomes and future costs. If those two have negative values, the store must be closed. Keeping the store open is related to both the memory of the initial investment and the fear of responsibility. As long as I don’t close it, I don’t acknowledge my failure.

Another aspect of the sunk cost effect is “I want to recover my investment”. If, for example, our store makes profit every year, but the profit is constantly below expectations and we will never be able to recover the initial investment, what do we do? Do we close it? No way! It’s another case in which the initial investment doesn’t matter, as it cannot be recovered and there is nothing better we can do with the store.

This kind of thinking, in which I want to “recover” in any way irrecoverable costs, leads to a related bias: the pro-rata bias. Let’s take another example. I spent one million dollars for R&D for a new product. Everything went well, the product is ready to be on the market. The marginal cost of producing a unit is one dollar, but I don’t take into consideration this low marginal cost, or the level of demand, or the price of similar products. I put a price of 100 dollars so I can quickly recoup the investment in research. Is this good?

The “sunk cost” trap is extremely common, causing different types of damage, from hours and hours of playing Farmville to aeronautical industry projects or the meaningless continuation of the Vietnam War.

How to counter sunk cost?

Think that you haven’t invested anything in that project so far, that someone gave it to you. Would you continue it? No? Then close it. In the example with the phone store: think that you took it today for free and it’s losing money. Would you keep it?

I have a personal example from when I fell into the same trap: I signed up for a longer triathlon and, during the training period, I had a knee pain. However, I continued to train and went to the competition, just because I was registered. However, if I hadn’t been registered and someone would have offered me a free registration, I would have never accepted the invitation, given my knee pain. Too bad that I didn’t think about this at the time.

Don’t seek the advice of someone who was involved in the initial decision. Don’t ask your oldest colleague, who approved the opening of the store, whether to close it or not. He’s as biased as you are. Ask a new colleague.

Cultivate in the company an atmosphere that lacks fear of failure.

Our houses are full of old things, which we no longer need, but which we do not throw away. If they weren’t ours and someone gave them to us now, we wouldn’t want them. But those things are ours, so we keep them. Our companies (and even our lives) have projects that we keep only because we have invested a lot in them.

Now that the spring is coming, how about we do a general cleaning?

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