Sunk costs are those that have been invested in a project, business, or idea and cannot be recovered. They are also referred to as an “economic loss” or a “dead money” by economists. The sunk cost fallacy is an important part of the startup concept. So, why should you care as an entrepreneur?
First, what is the sunk cost fallacy?
Sunk costs are costs incurred in the past that cannot be recovered. They are not considered in the decision-making process. The sunk cost fallacy occurs when people think that past decisions should have an impact on future decisions.
The concept of sunk investment is important to understand in entrepreneurship because it can lead to poor decisions. When a company has to make a decision about whether or not to invest more money in their business, they should consider their current investment and what the future returns will be if they continue investing.
In other words, the sunk cost fallacy is the tendency to continue a decision or action despite new information that makes it no longer rational. Sunk cost is a tricky subject as it can be seen in some startup mistakes and pitfalls. For example, if an entrepreneur has spent money on developing their product, then he or she will want to see immediate results from the investment, even if it means sacrificing more money on marketing and advertising campaigns. However, this can lead to a lot of wasted time and money if they don’t take this sunk cost into account when deciding what their next move should be.
Why does the sunk cost fallacy occur?
The sunk cost fallacy is a cognitive bias that occurs when people continue to invest in a project or endeavour. Even when the value of the outcome is low and it no longer makes sense to do so. It is a fallacy because it ignores the future value of an investment. Which is often greater than the current value of an investment.
Sunk cost fallacy affects decision-making processes. It can be seen as a natural human instinct to make decisions based on previous investments rather than current investment. The sunk cost fallacy stems from two primary sources: the need for certainty and the need for consistency. The first one is related to how humans are wired by our brains. While the second one has more to do with how humans want things to be consistent.
Who is most at risk of the sunk cost fallacy?
Entrepreneurs are most at risk for the sunk cost fallacy because they have invested so much time and money into their business already. making it difficult for them to see the light at the end of the tunnel when things are not going well. This is why entrepreneurs often find themselves stuck in a dead-end situation and fail to move on.
People who are at risk of falling prey to the sunk cost fallacy are those who are unable to break down their projects into smaller tasks. Or step back and reassess what they have accomplished so far. They may also be unwilling to admit defeat, despite knowing that they have wasted time and resources on a project.
It is also important to note that some people are more likely than others to fall prey to this cognitive bias. As they are more prone to regret and emotional attachment. When someone falls into this trap, they are also likely to fall victim to the planning fallacy and might not take action when they should.
Types of sunk costs
Several factors can contribute to a startup’s success or failure. One of the most important is the decision-making process of the founders and stakeholders. The three types of sunk costs that might keep startups from succeeding are:
- Opportunity cost: When you choose one option over another, or when you decide not to take a certain course of action because it would not be worth it in terms of potential benefits later on. For example, if you decide to take an unpaid internship rather than work for a company that pays better, your opportunity cost is the amount you would have earned at your current job if you had taken the job with the higher salary.
- Resources cost: What it takes to build something new like software or hardware. This includes all expenses including salaries, taxes, and materials.
- Time Cost: When you spend more time on a project, you may feel like the project is worth it even if it doesn’t have a chance of success. It may also feel like you have invested too much time to back out now.
Sunked costs can also either be fixed or variable. Fixed costs are those that remain constant regardless of how much product is produced or how many customers visit a business. Variable costs fluctuate based on how much product is produced or how many customers visit a business.
The impact of sunk costs on a startup’s growth
The theory of sunk cost fallacy is not new. It has been around for decades and has been used in many different fields such as finance, marketing, and psychology. In the case of startups, however, the sunk costs can be very significant because they often take up a large portion of the total budget for an organization.
Sunk costs include the initial investment, startup’s organizational structure, and human capital. These expenses usually increase exponentially with the size of the company, which leads to higher costs and less profitability.
The impact of sunk cost on a startup’s growth is often overlooked by entrepreneurs because they focus on the features and benefits of their product. However, they should be aware that if they don’t manage their resources well enough, then it will be difficult for them to scale up and grow sustainably.
The main reason why startups fail is because they have too many sunk costs. This means that they have already made investments in their business models and it’s difficult for them to change course when the market changes. The challenge with sunk cost is that it can be hard to let go of things you’ve already invested in. Even if it’s not working out for you anymore.
The sunk cost fallacy can be used to explain why entrepreneurs might make poor decisions. They don’t want to give up on their investment in an idea or product although the odds are against them. By understanding and recognizing this fallacy, entrepreneurs can make better decisions and avoid wasting time on bad ideas.
It’s human nature to try and get the most out of something, even if it’s not working out. However, when it comes to the business world, this can be detrimental to your success. When making decisions, we should consider whether the benefits outweigh the costs. Before considering whether we will be able to recoup our previous investments or not.