The Fallacy of Sunk Costs: Knowing When to Pull the Plug

“The most important thing to do if you find yourself in a hole is to stop digging.” – Warren Buffett

The fallacy of sunk costs refers to the tendency to continue with an endeavor in which we have already invested time, effort, or money and where those “costs” outweigh the projected benefit. There is an all-too-human inclination to invest additional resources, attempting to recoup the value of the previous investment, without considering whether the additional resource costs might outweigh any remaining benefits to be reaped.

Examples of this fallacy are all around us

The Concorde supersonic airplane is one of the best examples of a project that continued long after it became clear the financial gains of the supersonic airplane, once in use, would never offset the continually increasing costs. However, the project lingered for nearly three decades because the manufacturers and governments had already invested such massive time and financial resources that they hated to pull the plug.

If you are human, you have probably been subject to the consequences of the sunk cost fallacy. We often refer to this as throwing good money after bad. Have you watched a movie to the end, even if you didn’t like it after 15 minutes? Do you keep unworn clothes hanging in your closet for years because they were expensive? I would ask whether you have continued to try to repair a car that you knew was a lemon, but the money I sunk last year into trying to restore a ’94 Mustang would make that question altogether too hypocritical.

One business example of the fallacy of sunk costs is continuing with the development of a new product after you have realized it won’t meet your customers’ needs. Another is retaining a leader who turns out to have significant deficiencies in essential aspects of the role, because of the extensive time and resources invested in the recruiting process. As we said in our book, Mastering the Cube, spending where you shouldn’t prevents you from investing where you should.

According to Christopher Olivola, assistant professor at the Carnegie Mellon Tepper School of Business, there is a cognitive dissonance between paying for something and not getting the expected ROI. Sticking it out with the original plan is often an emotion-based attempt to avoid feeling the sunk costs were wasted.

How can Alignment Leaders® overcome the fallacy of sunk costs?

The sunk cost fallacy characterizes a striking violation of rational decision making. How can Alignment Leaders make necessary changes when decision makers have invested time, money – and maybe most importantly, their reputations – on business choices that are no longer working? The following tools can help leaders make strategic decisions and avoid falling prey to this mindset.

  • Omits & Guardrails: Every organization should document omits (things they say no to) and establish guardrails to prevent scope creep. Revisit these regularly to ensure that emotions or a fear of hurting feelings if the initiative is abandoned have not negatively influenced a pragmatic decision-making process.
  • Resource Allocation: Place your best resources against your most strategic initiatives. If you find your organization is over-committed on internal resources and the initiative is still justified, consider using out-sourced partners to help with the work as a temporary solution.
  • Evaluation Criteria: Assess potential initiatives against a set of pre-determined criteria (as already identified in your guardrails) or strategic principles that can measure strategic relevance and impact.
  • Prioritization: It should be clear to the organization which initiatives are on the action list and why. Prioritizing the initiatives early on saves a lot of time and emotion when situations arise where resource constraints require tradeoff decisions.
  • Information and Metrics: Use data reporting and business systems to measure progress, costs (in time, money, and human capital), estimated benefits, and to scope needed changes.

I was once called in to work with an executive team that was struggling to set strategic priorities for the organization. Their resources were stretched thin, which forced them into some tough trade-off discussions. Their biggest challenge was to determine what to do with initiatives already underway. In many cases, the in-progress initiatives were not as strategically important as other under-resourced projects. Executives had to ask themselves, “Do we finish what we’ve already started, or do we abandon those projects to direct our resources toward new efforts that will differentiate us from the competition?” In this case, all current and proposed initiatives were assessed against evaluation criteria and scored, based on strategic impact and resources required. Some projects made the cut, others were abandoned mid-stream, and some were outsourced.

A year later, this organization was taking over market share and becoming the dominant player in their space. Their leaders attribute this rapid success to their organizing choices: identifying and prioritizing strategic initiatives, using data to monitor progress, and creating a culture of objectivity. It became “normal” to discuss the strategic value of each project and hold the teams accountable for timelines, milestones, and outcomes. Quite naturally, the enhanced culture of empowerment and accountability led to enhanced rewards and recognition.

Mastering the balance between the decisions of the past, the opportunities of today, and the possibilities of tomorrow is essential. A clear understanding of strategic priorities and a willingness to pull the plug, when necessary, will ensure the fallacy of sunk costs does not drain your organization of its ability to succeed.

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