Posted by Micah Lorenc
Let's talk about a common topic in business schools, but less known small rural businesses. I am talking about sunk costs.
I recently had a conversation with a close friend who is looking for a new business opportunity, building a gym in a small rural southern Utah town. His new business is closely related to an existing fitness company that he created more than a year ago. The challenge he faces is that the creation of a new sports center would mean going in a very different direction from that of his current company. While we were talking, he was struggling to find a way to transform or merge his previous activities with the new gym without losing the investment of time and money he spent on the previous one.
After a brief discussion about the concept of sunk costs, he realized that his aversion to losing what he had invested in his old business was preventing him from moving forward and from To engage in his new business. Ignoring the sunk costs of his first venture, he released him and began offering exciting new ideas on how to grow his new business more effectively.
For those who need a sunk cost reminder, let's start with the basics. By definition, an unrecoverable cost is a cost that has already been incurred and can not be recovered. In appearance, it seems very simple. if I have spent money on something and there is no way to recover the money I spent, it is a sunk cost. However, when considering sunk costs in decision making, this is not always black or white.
The sunk costs become applicable in business decisions when you understand the sunk cost calculation error, which is: when we justify investing more in something because the resources we have already invested would be lost other. You probably think, "Well, obviously, I'm not going to let the sunk costs affect my ability to make good decisions." But that might be harder than you think.
In 1985, two researchers created an experiment to better understand unrecoverable cost errors. The subjects of the experiment were asked to assume that they had spent $ 100 for a ticket for a ski trip to Michigan. But soon after, they found an even better ski trip to Wisconsin for $ 50 and bought a ticket for that trip as well. The subjects were then asked to imagine that they knew that the two trips overlapped and that the tickets could not be refunded or resold, and they had to choose one or the other of the two trips. What trip do you think they have chosen? The good ski trip to $ 100 or the ski trip to $ 50 better? Well, it turns out that more than half of the study participants chose the most expensive ski trip, $ 100.
This study reveals a human behavior that is a huge handicap when it comes to making good decisions. This shows that loss aversion is a higher priority than value creation. The study subjects were virtually guaranteed that the $ 50 trip would be an even better experience than the $ 100 trip, yet more than half of them still chose the $ 100 trip. Why? Because the loss was greater. If they chose the trip for $ 50, they would be out at $ 100, while if they went with the trip to $ 100, they would lose only $ 50. This is the fallacy of the costs at work because the money is gone anyway. In this scenario, you spent $ 150, period. You can not get it back, and yet most people have only tested the estimate of the potential loss, and they have not even considered the value they would get from each option.
The unrecoverable cost error has an emotional component related to loss aversion that prevents you from realizing that the best choice is the option that promises more value, not the one that minimizes losses. This is the same reason why some people can not leave the blackjack table after losing money. They take into account what they have lost to decide to continue playing.
If you find yourself in a situation similar to that of my friend, struggling with a difficult decision to make and there are various alternatives that seem to have an emotional component, ask yourself the following question:
Do I consider some options that I might not be able to do otherwise because I try to minimize my losses?
Then continue with this question:
What alternative would offer the greatest value in the future?
Learning to let go and move on may reveal some of the best opportunities for your business.
Micah Lorenc has family ties and attended high school and high school in a small town in southern Utah. For the past six years, he has worked on strategic planning and corporate architecture at a Fortune 100 company, and is dedicated to sharing business strategy lessons with small businesses. His specialty is teaching small businesses and entrepreneurs how to set effective long-term goals for their business and help them break down their strategy into concrete steps.