The Sunk Cost Fallacy Works Both Ways

27 Jun 2023 11:40 AM | Ali Kucukozyigit (Administrator)

by Donald Kennedy, Ph.D., P.Eng., IntPE, CPEM, FASEM

Sunk Cost

We have probably all heard about the sunk cost fallacy. To recap and refresh memories, the common understanding is that proper economic evaluations look at the return of money to be spent and to not get hung up on the past.

My Professional Experience with Sunk Cost

Some companies I have worked for will look at a few billion dollars they invested in something and use that to justify spending a few more hundred million to keep that business line going.  They view the hundred million dollars as the investment to make the billion not be a failure. Of course, the proper way to analyze the situation is to look at what return you will get for investing that hundred million. If you cannot get $20 million a year in return, it might not be worth doing. The billion is spent and gone and should not be worked into the decision making of future cash flows.

My Personal Experience with Sunk Cost

Searching for the term “sunk cost” I did not find the flip side, however. I encounter that fallacy enough times as well. Around 2000, I bought a dishwasher for around $400. It repeatedly gave problems after the warranty ran out and I even rigged a bent nail into the door latch to make it work at all. After a few seals, vents and springs broke and motors seized,meaning the cost to repair was more than the cost of a new one. I bought a different brand for $800 that had a door latch that looked more robust. 

It worked well for a number of years and I was happy with my purchase. Then it stopped working with an error message on the panel. Searching the internet, I discovered a fix that involved taking out of its cubby, tipping it 45 degrees, and putting it back. There would be a puddle on the floor to clean up, but it worked for a while. After a few years, the rate of having to tip it became frequent and then it would not work at all. I spent $250 on a repair call and it worked for a short while. Then I spent $350 on another repair and it worked for a while. At this point the repair person definitely narrowed down the root issue and it would cost $250 to do that repair and the machine should work fine for years. 

Now if I followed the sunk cost fallacy, I could say that if I spend another $250 that will bring the total spent on repairs to $850 which is more than a new machine. However, I reasoned that I will spend $250 and save having to buy a new machine. I went with the final repair and it has worked well for 2 years with no signs of problems.

So What?

Software expenditures at companies often fall to the sunk cost fallacy. The implementation of a system may run into the tens of millions. To get additional functionality once it is up and running may cost another $300,000. I saw managers say that $30 million is enough and cancel all further modifications. Or a company builds a $1 Billion facility that does not perform as planned. The fixes run into tens of millions to tweak, similar to my dishwasher. Instead of looking at the investment to fix, in the case of the employer I worked at, the management said $1 Billion was enough and they did not want to be continually tied to that investment and be budgeting for solutions to performance issues. They decided to liquidate the facility and take a one time hit.

It is counterintuitive to think that large investment decisions can be tied to the emotions and egos of the people making the calls. But management would be easy if there were no people involved, wouldn’t it?

PS: At the time of writing, his dishwasher is functioning within spec.!

About the Author

Dr. Donald Kennedy, Ph.D., P.Eng., IntPE, CPEM, FASEM is a long time contributor to the Practice Periodical. After spending a few decades in the world of heavy industrial construction and operations, Dr. Kennedy finds himself celebrating a one year work anniversary in the world of ERP driven operations and assembly line style manufacturing.

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Missouri S&T

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