The sunk cost fallacy is the phenomenon of making future decisions based on past results instead of future benefits. This happens a lot in business, and part of the problem is a misunderstanding of the cost-benefit analysis process.
How To Assess Costs
Assessing costs in business should be done using an expectation of future profit from current decisions. In other words, a projection is done based on reasonable assumptions and current costs for a project. So, if you are thinking of developing a software tool, the first step would be to think about how much money you will need to spend to get a minimum viable product.
Next, you need to know how much you expect to make from that software product. Finally, you need to determine if the profit is sufficient to warrant development.
This largely forward-thinking process relies on certain assumptions, namely future profits. However, for long-term analysis, many companies find it necessary to also discount future income to current dollars.
For example, if a company’s long-term profit projection spans 10 or more years, it may be helpful to calculate the current value of future income from the project. This helps the company understand the inflation-adjusted income or profits from the venture, since this can also affect whether a company should move ahead on a project or not. A company’s profit might be eroded quickly just from inflation, especially in software and technology, where profit margins are already thin.
Companies, like Blitz, use this approach when trying to determine whether it’s the right time for software upgrades.
How Many Businesses Assess Costs
Many businesses, use past costs to justify future expenses. This is a huge mistake. Why? Because past costs are lost. When you write off those costs, you’re finished with the project – even when you don’t write down losses on your corporate taxes (why wouldn’t you), those costs can never be recouped. Not really.
The sunk-cost approach to analysis isn’t so much a financial strategy though as it is wishful thinking. It’s completely subjective in the sense that, while the numbers (the money) spent are real (they’re objectively quantifiable), they don’t mean anything.
Most companies who suffer from sunk-cost analysis are steeped in tradition, they have legacy systems that they can’t update, or they have on-site software (as opposed to cloud-based software) that’s not scalable and expensive to upgrade.
They literally don’t know what to do, so they dig their heels in deeper and refuse to change because it’s painful.
Don’t let this happen to your company. At the end of the day, it might be painful to scrap a project you just spend $200,000 on, but it’s also a lot cheaper to let your ego go than to spend another $500,000 on something that will never work properly.
Ways To Check And Avoid The Sunk-Cost Fallacy
When you’re in development, always check to make sure that past costs are not being factored into the analysis. If you’re updating a project, don’t take into account everything you’ve spent so far. Just include what you’re about to spend on the project.
Tiffany Stevens is a part time secretary for a small business. In her free time she likes to research and write about business topics to share on the web. Look for her illuminating posts on various blog sites and websites, too.