SUNK COSTS SINK SHIPS
The NFL example: And it happens all the time.
An NFL franchise signs a quarterback to a $200 million dollar contract. Early in the season it is clear that the franchise overpaid, because the quarterback stinks. The team gets off to a 0-4 start. The quarterback gets hurt in game 5 and the team is forced to play a rock star rookie, who proceeds to guide the team to 4 straight victories. The high priced quarterback gets healthy. The owner calls the head coach and says, “we need to play the high priced quarterback now because it doesn’t make sense to have $200 Million sitting on the bench”. This is an incredibly bad idea and the absolute wrong strategy, but it happens all the time in major league sports because of unintelligent billionaire owners. The objective is to win, and the strategy comes second. The strategy of the $200 million quarterback proved to be the wrong one. Owners do it because they have huge egos and can’t admit they are wrong. The $200 million QB proved to be a bad strategy. Better yet, you established a better strategy. No matter what you do, you have spent the $200 million, so the question becomes, what do we do NOW to win? You play the best player. In the first four games you spent the money and lost every game. In the next four games you spent the same money and won every game. Which strategy is better? The $200 Million is a sunk cost and can’t be retrieved. You need to say, “we spent that money on a bad quarterback; given that, how do we win?”
Before you start laughing at your favorite NFL franchise owner, how long have you allowed an underperforming player on your team stick around because of their “credentials”?
Business example: It happens in every department.
Your Company builds a brand strategy that included a $1,000,000 advertising campaign, and halfway through the campaign you realized it was hurting sales. What should you do? Most companies say something along the lines of “we have $500,000 invested in this project and we don’t want it to go to waste. Let’s see it through and stay the course”. They failed to realize that the first $500,000 is already in the garbage can in the lunchroom. The question is what is the best use of the remaining $500,000. Companies throw good money after bad all day long. You need to say, “we have spent $500,000, now what is the best use of the next $500,000 to drive sales”. The first $500,000 is a sunk cost and can’t be retrieved.
Before you start laughing at the Marketing Manager, when was the last time you stayed the course on a bad idea because it was YOURS, and you didn’t want to lose face? The courageous thing is to punt and move on.
Investment example. We all do it.
I worked with a great guy who had accumulated almost $1,000,000 of Company stock over his long history with the Company. There were very good things happening with the Company and the stock rose significantly over time. Many advisors told him to sell his stock, but he chose to hold on to it. The stock dropped to less than 50% of its highest value. I spoke with him and asked him if he was going to sell. He told me that he couldn’t sell because he was already “down” 50%. I asked him what that had to do with the decision he needed to make. He was perplexed. I then asked him if there was any reason the stock would return to its original value anytime soon. He said no and I asked, “then why would you keep it”? He could not answer the question. He needed to say, “I lost $500,000, but I still have $500,000, now what should I do with that $500,000 to maximize my return. “ He didn’t listen to me. He sat on the stock for 10 years and it is still only 70% of its original value. If he would have invested in the 10 year bull market, he would have $1,500,000. Not understanding sunk costs in investing cost him $800,000. The lost $500,000, is a ‘sunk cost’ and should not dictate what to do next.
Special note: Not understanding Sunk Costs kills people when they are investing. Don’t be that person. Do not let “what you paid” dictate what you do. Before you laugh at my friend, how many stocks are you sitting on because you are “down” and waiting for a recovery? Sell them and buy something better.
The personal example: And you do it every day
You have purchased two concert tickets for $200 each, and the concert is this Sunday night. While this is a good band, it’s not your favorite, and you just thought it would be a “good night out”. Today is Friday, and it just so happens that the Super Bowl is in your city this year on Sunday and a friend calls you and says, “you won’t believe this, but I just won two tickets to the Super Bowl on a radio call in show. I would like to know if you want to go with me. No charge”. At first you are blown away by the offer and then you realize that you have concert tickets that you already paid for. What do you do? If your answer to this question aligns with the way many people handle this situation in business, it will be, “Gee, friend, I’d love to, but I can’t. I already spent $400 on concert tickets that night, and I would hate to see that money go to waste”. This is faulty thinking. The only outstanding variable is what is going to be done with your 3 hours on Sunday night. Do you spend it watching a concert, or do you spend it watching the Super Bowl live? The $400 is a sunk cost and can’t be retrieved. Not that football is better than concerts, but I bet the Super Bowl tickets are worth more than $400. You need to say, “I spent $400, where do I want to spend Sunday night”? Go to the Super Bowl and sell your concert tickets on Stub Hub.
Before you start laughing at the concertgoer, how many times have you said, “I can’t make it, we have plans”? The only way that logic works is if the first plans are better than the second plans. Sometimes you need to say, “my original plans are boring, what do you have in mind?”
Five Tips for recognizing and managing sunk costs
- Sunk costs will be the same, regardless of the outcome of the next decision.
- No matter what you do, you have spent those resources and the objective that lies before you is to win, knowing that the money, or time, or people, behind you are not recoverable.
- Sunk cost understanding flies in the face of human nature. Why do people and companies do this? Why do they throw good money after bad? Why do they invest time into projects that are proving failure early? The answer is humans are prone to “loss aversion”. That means that they will do anything in their power to avoid, or postpone failure. Don’t postpone failure, recognize it.
- The important point of sunk cost is realizing that you are failing as soon as possible and course correct. Fail fast and change direction.
- Don’t ever let pride dictate your future decisions