The Sunk Cost Fallacy

The Sunk Cost Fallacy
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If you or your company has invested in an innovation or project, and it just is not working, when is the right time to stop it?

Or if everything is going fine in your company but the market is changing, how do you know when to change the business model?

Research shows that the more an individual or company has previously invested in something (whether it be money, time or effort), the more likely they are to want to continue doing it, even if the correct decision would be to stop.

Classic examples include the development and installation of hugely complex IT solutions, which begin but keep missing their deadlines and budget, yet continue to be funded even though it would be more effective to start again from zero and invest the money elsewhere. For example, the NHS Connecting for Health system was originally planned to cost GBP 2.3 Billion, but was discontinued before completion after spend reached GBP 12 Billion.

This is known as the Sunk Cost Bias or Sunk Cost Fallacy, and it can be a killer of Innovation Labs and innovation projects.

Originally popularised by Daniel Kahneman and Amos Tversky, the Sunk Cost Fallacy has had some interesting research studies confirming its existence:

In a landmark 1985 study by Arkes and Blumer, participants were put into the position of a CEO of an aerospace company, being asked whether the last $1 Million of their research budget should be spent on researching a new Stealth Plane. The participants were however also told that a competitor is marketing that they already have a similar plane in development which is faster and cheaper and would make their product obsolete. They were then asked whether the $1 Million should be spent on the research project (Yes) or not (No). However, there were two scenarios:

  • Half the group were told that the project had not started yet, and this was the last $1 Million in the budget. Result: 17% said yes
  • Half the group were told that the project was already 90% complete, and this was the last $1 Million in the budget. Result: 85% said yes

Just the fact that a project had already invested heavily in the past made people 5 times more likely to continue the project.

In corporate terms, another way of describing this is Escalation of Commitment, where companies double down and actually invest more than they previously did in a product or business model after finding out it is going obsolete.

Other experiments with a more hypothetical investment of time or budget have shown only insignificant sunk cost effects.

One of the reasons for why the Sunk Cost Fallacy may exist is due to Loss Aversion. It has been shown that it feels significantly more painful to lose something you already have than it would be to start from zero. Therefore, it would fell more uncomfortable to feel like previous investments are shown to have no value. As long as a project continues, it feels as though the previous investment has not lost its value yet.

However, this is not necessarily the best decision for the company. Sometimes projects should be stopped and the money and resources which would have been invested can be better used for other new innovation projects. A rational decision maker should only consider future costs, not past ones.

This is not always easy. Especially for founders of startups or the innovation team which came up with an idea. Because these people have not only invested time and money, but the emotional investment with this being their own idea. They can feel like these ideas are their babies and it is their duty to force them to be successful. This can be one of the primary reasons why many innovation labs are not successful: they focus their efforts very early in the funnel to bring a project to an MVP stage, and then feel like it is their duty to make it succeed.

Even if the market is telling them that the innovation does not have product-market fit.

Instead, ideas should be looked at from a neutral perspective, as part of an overall portfolio. And progress should be validated in an unbiased way, like a scientist would. And projects which are not delivering to be stopped and have their resources redistributed.

Think of the sunk costs you have already spent as a present from your past self to your current self. They may have got you to where you are now, but they are not necessarily the right way to go forward anymore.

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