Explanation of the Sunk Cost Fallacy
Businesses incur costs on a daily basis. While most of these are written off, there are some that will fall into the sunk cost category. These costs are typically large in nature and will accumulate over time. The idea is that many companies start projects with the goal of them being profitable. However, as time goes on, a project may be deemed a failure or may even have to be halted because of financial problems. However, the sunk cost fallacy would simply not allow for such an event to occur.
Explanation of Sunk Cost
There is an idea that a business will have sunk so much resources into a project that there is literally no turning back. This occurs because too much money has been allocated for employees, equipment and other resources that the business will do anything to save the project. It is simply a matter of putting too much effort into a project to let it not be realized. This may seem like the case for some business projects, but this simply is untrue.
A Prime Example
Understanding this fallacy takes an example. With sunk cost, let’s use the example of a project that has the current objective: “A video game based on MMO technology that is 2D-based.” This would have been a multiple million dollar endeavor that any company would have to take seriously. However, if this endeavor panned out, the company could stand to profit greatly.
During the first year, everything seems like it is in order and a deadline has been set. However, deadlines have been pushed back because a lead developer has left the company. Furthermore, some of the game’s features proved to be much more difficult to program and now the project has been extended by at least another year.
Year two may seem perfect as everything is already going as planned. However, some of the features needed are simply in the development stage and progress has been rather slow. Other games are currently hitting the market and are selling well. However, other MMO genre games are coming out as well, which means competition is fierce.
Year three starts to show signs of failure. While the game is now more than half done, the market shows a demand for something different. In fact, 2D games are no longer popular and the projection of sales is simply cut into fourths. This is horrible news and will have to put a halt to the development of your new and fun game.
The problem with projects is that they are merely ideas until they have been fully developed. The fallacy would have called for the business to keep putting money into the project even though it does not have current projections to cover the costs. In fact, this fallacy states that a business will simply keep putting money into a failing project to make it a success. This, however, is not good business practice.
When a Project can Persist
There are times when a doomed project can keep moving forward. While it may be difficult to determine, if the profits stand to be made are greater than the cost left on completing the project, it may be one that simply has to continue. For instance, if the sales figures stated that $100 million dollars was still to be made regardless of the market and a company only has to invest another $10 million into the project’s completion, it may be a project that is simply too good to give up on. However, if losses will occur or there are no valid profits to be made, the project must be terminated.
Why Sunk Cost is a Part of Business
Every project has to be started with a slim probability of failure occurring. If a business is simply too attached to a project to let it go, they will find themselves suffering from major losses. Any smart business will understand that investments do not always work out the way that they are intended. When a project is no longer worth saving, this will need to be brought to the attention of the owners and a remedy must be made. Sometimes, a project can be sold off and other times it will simply have to cease.
Sunk cost is rather complicated, but it is a part of business. When the investment in a project is no longer worth the cost and profit projections are low, this may mean that all of the previously invested money is a loss. While every business will have difficulty dealing with a loss, it is merely essential. The only reason to save a project would be if the projected profits would still be in the positive. If the rest of the investment would be less than the profits of the completed project, it may be feasible to continue with the overall project.