Sunk Costs

A sunk cost is an expense that has already been incurred and has no bearing on future decisions.

Imagine that you are working on restoring an old car and have budgeted $2000 to complete the project. After all the repairs are made and you turn the key, you hear nothing. You learn that it will cost another $1000 to get it operational. Conventional wisdom says that the decision to proceed or not is based on the total amount spent, or the $3000. Even the old adage “Don’t throw good money after bad” reinforces this train of thought.

In reality, though, the first $2000 is irrelevant at this point. It might feel bad to have spent it, but whether the project moves forward or not, the money is gone. The decision, therefore, at this point is whether getting the car running is worth $1000. The $2000 is a sunk cost and will remain spent regardless of whether or not the car ever gets back on the road.

Sunk costs are a very difficult concept for many people to understand. There is an emotional commitment that builds as time and money is invested into a project. It can be hard to walk away from that investment, even if it will still take a substantial amount of money to complete.

Let’s look again at the hypothetical car project. At the beginning of the project, perhaps if you believed it would take $3000 to get the car running, you would have passed on the project. But since the estimate was only $2000 it was attractive. The problem, of course, is the same one you will run into in the business world. Information is not perfect. Sometimes you get your estimates wrong.

But fast forward to the point where you realize that you have to spend $1000 more to get the results (a functional car) that you want. If you just came upon the car at this point, with no knowledge of the previous expense, you would likely jump at the project. It is actually twice as attractive as it was when you first considered it, since it is half the price. Walking away from the project represents a missed opportunity.

That is not the most serious failure mode with sunk costs, though. The worse problem is that people tend to treat spent money like a benefit. It becomes a form of reverse accounting, which is especially bad when a project becomes a money pit. Perhaps instead of $1000 more to fix the car, it was $3000. The same person who would have rejected it outright at the start might look at it differently because of the money that was already invested. The brain has a conversation that goes something like this: “Sure, it will cost $3000 to fix, but we’ve already got $2000 in the project.”

It is as if the question shifts from “$3000 vs. a working car” to “$3000 vs. a working car plus $2000”. The only problem is that there really isn’t a $2000 in the second equation. It’s already gone.

This incorrect accounting comes from the emotional component of decision making. You likely won’t be able to get the two grand you spent out of your head. This is particularly prevalent with executive who have egos attached to projects. Walking away from it highlights the failure.

Now, that isn’t to say that when it comes time to review the success of the project that only the last $1000 should be looked at. The whole $3000 must be considered to determine whether the project was worthwhile, and any lessons learned have to come from looking at the whole project, not just the back end.

That is, in fact, one of the big Lean takeaways from this article on sunk costs. The PDCA cycle entails a constant review of projects. At every review, only the cost to continue the project should be considered. The lessons learned earlier will certainly affect the cost-benefit analysis, but when crunching the numbers, look forward, not back.

Another Lean lesson is to do a post-mortem on projects to see where they went wrong. The goal is to constantly improve so the initial estimates of time and money are more accurate. The more accurate the estimates around a project are, the less important the concept of sunk cost becomes.

Sunk Costs Words of Warning

• Don’t let sunk costs be a crutch or a tool or a shady bypass method to get around bad planning. Watch out for people fudging the numbers, knowing that they will be able to claim that the expenses are sunk costs later.

Sunk costs are a very difficult concept for many people to understand. There is an emotional commitment that builds as time and money is invested into a project. It can be hard to walk away from that investment, even if it will still take a substantial amount of money to complete.

Let’s look again at the hypothetical car project. At the beginning of the project, perhaps if you believed it would take $3000 to get the car running, you would have passed on the project. But, since the estimate was only $2000 it was attractive. The problem, of course, is the same one you will run into in the business world. Information is not perfect. Sometimes you get your estimates wrong.

But fast forward to the point where you realize that you have to spend $1000 more to get the results (a functional car) that you want. If you just came upon the car at this point, with no knowledge of the previous expense, you would likely jump at the project. It is actually twice as attractive as it was when you first considered it, since it is half the price. Walking away from the project represents a missed opportunity.

That is not the most serious failure mode with sunk costs, though. The worse problem is that people tend to treat spent money like a benefit. It becomes a form of reverse accounting, which is especially bad when a project becomes a money pit. Perhaps instead of $1000 more to fix the car, it was $3000. The same person who would have rejected it outright at the start might look at it differently because of the money that was already invested. The brain has a conversation that goes something like this: “Sure it will cost $3000 to fix, but we’ve already got $2000 in the project.”

It is as if the question shifts from “$3000 vs. a working car” to “$3000 vs. a working car plus $2000”. The only problem is that there really isn’t a $2000 in the second equation. It’s already gone.

This incorrect accounting comes from the emotional component of decision making. You likely won’t be able to get the two grand you spent out of your head. This is particularly prevalent with executive who have egos attached to projects. Walking away from it highlights the failure.

Now, that isn’t to say that when it comes time to review the success of the project that only the last $1000 should be looked at. The whole $3000 must be considered to determine whether the project was worthwhile, and any lessons learned have to come from looking at the whole project, not just the back end.

That is, in fact, one of the big Lean takeaways from this article on sunk costs. The PDCA cycle entails a constant review of projects. At every review, only the cost to continue the project should be considered. The lessons learned earlier will certainly affect the cost-benefit analysis, but when crunching the numbers, look forward, not back.

Another Lean lesson is to do a post-mortem on projects to see where they went wrong. The goal is to constantly improve so the initial estimates of time and money are more accurate. The more accurate the estimates around a project are, the less important the concept of sunk cost becomes.