Project sponsors often get confused regarding continued funding of the project, while, in reality, the project’s objective is lost and is no longer relevant.
For example, after spending over 75 million USD on the construction of the Shoreham Nuclear Plant, the company fell committed to funding, and the cost escalated to 5 billion USD, and the plant never became operational.
This money already spent or committed is called sunk cost, and this amount is irrecoverable. Sunk cost is sometimes known as a retrospective cost.
The sunk cost affects all industries. Economists see sunk costs as a trap and try to avoid it.
Definition of Sunk Cost
Definition: Sunk cost is the money committed to a cause of action and is irrecoverable, and it should not form the basis of decisions for future actions.
The sunk cost is an outlay that has already occurred; hence, it should not affect the decision under consideration.
Furthermore, many economists call sunk cost sunk capital because they cannot invest it in alternative use because they are invested, and you cannot reverse it. e.g., labor charges, consumables, plant, machinery, etc.
Example of a Sunk Cost
A business planned to increase product sales because of the thriving economy. They hired consultants to conduct a feasibility study and started the pre-planning. They have invested 25,000 USD to date.
However, because of the sudden political conditions, the economy is in recession, and sales are down. So, now the business has shelved its plan for new production.
In the above example, the invested amount, i.e., 25,000 USD, is the sunk cost.
Psychology and Dilemma of Sunk Cost
The theory of rational behavior assumes that humans make decisions based on the expected utility, maximum profit, or minimum cost therein. In essence, value judgment drives the decision.
Humans have feelings and emotions which sometimes contradict rational behavior. Sunk cost poses a difficult circumstance to business decision-makers whether to continue a project or operation that has swallowed a huge cost or discontinue it.
It pains to see the investment has gone into action with no perceived value. Bias sometimes comes in. It is difficult to override instincts. Fund availability is another factor that could cause one to fall prey.
Sunk Cost Effect
The sunk-cost effect is a judgmental error attributable to money already spent on a venture. It is the human tendency to continue an endeavor once you invest (time, money, or effort). The prior investment drives the current action against the goal or business sense in the endeavor.
Psychologically, businesses defend this behavior on the ground that they do not want their investment to appear wasteful.
Some explanations for this behavior, as suggested in the theory of escalation of commitment, are:
- Self-Justification: It happens when the decision-maker is reluctant to admit a prior mistake. Hence, they allocate additional resources to the project or operation.
- Project Completion Hysteresis: This is where a decision-maker is motivated to invest more resources because the project completion date is coming nearer regardless of whether the project’s value still stands.
- Entrapment: This is where, as time passes, the desire to achieve a goal surpasses the desire to minimize cost-benefit ratios.
- Optimism and Illusion of Control: The decision-makers overestimate a project’s value.
Families of Costs
- Economic Cost: This is the actual cost of a commodity or a decision plus the opportunity cost.
- Opportunity Cost: This is the cost of the best alternative to a decision made.
- Sunk Cost: This cost has already been incurred and is not a consideration for a new investment decision. It is money irrevocably committed and cannot be changed.
- Book Cost: This is the original cost less depreciation representing the value of an asset as reflected in the firm’s books.
- Incremental Cost: The cost incurred for producing an additional product unit.
Lessons for Project or Business Leaders
Project sponsors and business leaders deal with the challenges of choosing among projects with limited resources, which we refer to as portfolio management- -the identification, prioritization, authorization, management, and control of projects and programs (Archer et al., 1999).
Sunk cost effect manifesting in the escalation of commitment is in the management of project portfolios. They may need to consider terminating non-performing projects to assign resources to promising projects.
Some reasons project sponsors consider terminating a project are:
- Time and budget overrun.
- Obsolescence.
- When the project cannot give the envisaged business benefit.
Decision-makers resist the temptation of terminating a project they have committed funds into. In the political sphere, terminating a project in which they committed taxpayers’ money is considered unconscious handling of taxpayers’ money.
The following can help overcome bias due to sunk cost:
- Use the Life cycle model where decisions for fund commitment are made by comparing future revenue to future costs. In line with this, the time-adjusted rate of return (TARR) for future, not past costs, is determined compared to competing choices/projects.
- Technical expertise in interpreting unambiguous negative feedback and its consequences to broaden the manager’s view on the decision problem and reduce uncertainty.
Reducing the Sunk Cost Bias in Decision-Making
Using the 7-pointer questions from the Women Who Money blog, you can reduce sunk cost bias. A manager or decision-makers should sincerely consider this:
- Suppose you were to start over at the beginning of your decision-making process. Would you make the same decision again?
- Are you giving up other opportunities to continue with the status quo simply because you committed a long time ago?
- Have things changed since you made the initial decision, making it less beneficial?
- Do you have more information now than when you made the initial investment? Does this information impact that decision?
- Are you afraid to admit you were wrong? Do you (unhappily) stick with a decision even though you realize it was a mistake?
- Would you tell a close friend or relative to make the same decision?
- Are you trying to avoid the discomfort of change in the short term? Try to think of the long-term consequences.
Sunk Cost Vs Relevant Cost
You consider the relevant cost while making a future decision; on the other hand, the sunk cost has no impact on the future decision.
You compare the relevant cost with the revenue of choice and decide.
Relevant cost is variable and affects the decision, while sunk cost is fixed and already incurred.
Conclusion
Sunk cost is more of physiology than rational. It is prevalent in everyday life from education, money, time, effort, etc. It is deeply rooted in bias, but decision-makers can handle it and put the company’s interest above personal reputation by considering the odds, opportunities, and future.