Sunk Costs and Costly Decisions

Want to know why some people lose so frequently at poker? It’s not because they’re unlucky. It’s because they’ll often add chips to the pot generously during the early bets while they’re figuring out if they have a good enough hand to play… but by the time they realize they DON’T have a good enough hand to play, they feel that they’ve paid so much already, they should keep playing just in case (even though the odds of winning are now largely stacked against them).

This happens in business, too. A business owner will invest in something (a tool, a piece of software, an employee, or a new asset, just to name a few) in order to help their business. Things go well for a while, but sooner or later that thing is no longer useful, but the entrepreneur keeps using it because they feel that they’ve paid for it so they should try to derive as much value as they can out of it.

Although it’s a common practice, it’s a mistake… and it’s often a costly one.
The whole idea is based on a concept called “sunk costs”. When you buy something, that money goes away and it won’t come back. It’s “sunk”.

Now, the item (or asset or employee or whatever) that you spent that money on might have some usefulness for a while… but nothing lasts forever. When their usefulness runs out, the best thing you can do is:

1. Stop using it
2. Find something better to replace it
3. See if you can derive any resale value from it

The LAST thing you want to do (but the thing that most entrepreneurs default to) is to try to continue using the item long past its usefulness just because you paid for it.

It’s a costly decision because the value of that item is no longer a value added to your business. Rather, it’s a perceived value about how much you need to use it before you’ve “got your money’s worth”.

Here’s an example:

An entrepreneur buys a piece of software for $500. It helps him grow his business and he uses it every day. But after one year, it’s not really running as well as he wants and his business has expanded beyond that software’s usefulness. The entrepreneur becomes disappointed, and calculates that it cost him about $2/day ($500 divided into 250 workdays). He feels that the value he SHOULD have got from that software should be $1/day at the most, so he does his best to use the software for another 250 workdays.

The entrepreneur is making the classic sunk cost mistake. He is ignoring that the $500 has helped him grow his business dramatically and earn thousands of dollars and he is forcing the software to continue to work even though its usefulness is no longer there.

Take a long look at some of the investments you’ve made in previous months and years. Are they delivering the value they should be delivering? If not, consider them a sunk cost and move on.