Don’t Let Sunk Costs Be an Anchor on Your Business

By Preston Sumner and Brian Rouff

Preston: Brian, when you described tearing down and rebuilding your business model, the phrase that came to mind was “creative destruction.” Besides being a powerful concept from John Boyd’s OODA process, creative destruction goes against the grain of the human tendency toward the “sunk cost fallacy.” It is human nature to feel the need to continue with something in which we have made an investment. This is the psychological bias that causes us to continue watching a movie that we bought a ticket for even if we are not enjoying it. It’s why too many businesses don’t make changes in their business models, in their product lines, and in their employees when performance is lagging.

As you point out, there were issues in your industry that made the need for a new business model obvious. Recognizing the psychological bias or “sunk cost fallacy” is not always easy. How can business leaders recognize and overcome this psychological bias? Here are a few questions to ask yourself and suggestions:

  • Has your market changed dramatically?
  • Are you facing the brutal facts revealed by comparing your financial reality to your original financial forecast?
  • Is the original payoff still as big?
  • Does it still contribute to your long-term objectives?
  • Knowing what you know today, would you invest in your current business model?
  • Don’t mistake persistence for beating your head against the wall.
  • Are you afraid to fail? It’s not failure, it’s learning.
  • Think of all past decisions as experiments. Viewing them in this manner makes it easier to change course.

Creative destruction can be thought of as simply changing your mind and getting another “at bat.” And as any salesperson knows more opportunities mean more sales.

Or to put it more simply, “If you find yourself in a hole, stop digging.”

Brian: No question, Preston (does that rhyme?), change is hard. But not changing can be even harder, especially when you feel the company’s survival is on the line. For us, it started with awareness that many firms in our industry were gutting their staffs or folding up their tents entirely. Not coincidentally, they shared a common characteristic: they waited too long to change, or refused to change at all. Your analysis of sunk cost fallacy addresses the “why.” I’d like to add my two cents.

Having lived in Las Vegas for nearly four decades, I’ve observed blackjack players, for example, lose 10 or more hands in a row. And yet, they keep pushing money out there, relying on something statisticians call the “gambler’s fallacy,” in which they feel the cards are “bound to turn” or are “due.” The misconception is that each hand is reliant on the ones that came before, when in reality the dice or cards or slot reels have no memory; each play is an independent action (unless you’re a professional card counter, which is a subject for a different essay.)

Referencing your movie remark, I know I hang in too long because I keep hoping the film will get better. And while hope, faith and optimism are largely thought of as positive traits, they can also be destructive if overused, especially when they have no basis in reality. This, it seems to me, is another component of sunk costs. The old time gamblers say it best: “Don’t throw good money after bad.”

So how do you know when to instigate change? It’s a combination of art and science, based on elements like judgment and experience, but also astute observation of internal and external cues. Then factor in each individual’s tolerance for risk, coupled with the corresponding ability to recognize when the risk of standing pat exceeds the risk of taking decisive action.

I’m often reminded of business management guru Tom Peters’ advice, “Ready, fire, aim,” which is a useful way for entrepreneurial companies to test the market without committing large quantities of resources.  Or, as that wise philosopher “Anonymous” once said, “When in doubt, make a decision.”

Brian Rouff is a creative business owner. As managing partner of Imagine Communications (www.WeAreImagine.com), a leading Las Vegas based marketing communication firm, he is responsible for business processes. However, Brian is also part of Imagine’s creative team and a published author, so he has a foot in both camps.

Preston Sumner, President of CEO Focus of Nevada (www.ceofocusnv.com), is a curious observer of and participant in business. His curiosity extends to domains such as psychology, sports, physics, and warfare. He finds that these other domains offer models and lessons for business performance. Preston is fascinated by the intersection of knowledge and performance. Together Brian and Preston will explore this tension between creativity and the process of business.