12-brents sunk costA friend of mine from college drives a Lincoln Towncar with 240,000 miles on it. There is always some piece either falling off of it, needing replacement, or it’s just not working right. It’s a maintenance nightmare. About every three months, something blows out on that car and you just know when something goes wrong, it’s going to be expensive.

It’s like an old shoe he never wants to let go.

Every time something breaks on that thing, it’s just painful to listen to the money that has to be spent on fixing it.  I keep thinking “Jeesh, just buy another car already”.  But each time it’s fixed (begrudgingly, of course), everything is hunky-dory for a few more months.

Sunk Cost

It made me think of the concept of sunk cost and how, if we’re not careful, we tend to make really strange decisions because of the way our minds are wired. When sunk cost starts creeping in watch out — incorrect decisions are soon to be made without your realization.

Now my friend is  going to read this and think “Hey now, the car is just fine – I’ll just sell it when something goes wrong next time”.  But I’m going to prove, through a little creative writing, why he needs to sell that piece of junk car like 3 years ago.

A sunk cost is anything you’ve spent money on that can’t be recovered. Like my friend’s car, the money he spent buying and maintaining it are gone forever. Since the money can’t ever be recovered, traditional economics would tell you that the dollars spent should never enter your mind when making a future decision about the car. With the advent of behavioral economics, however, everyone soon realized people don’t necessarily think the way we predict.

So the other day when my friend said “Hey man, you’re never going to believe this, but the brake pads are all rusted out on my car [sigh] and need to be replaced – it sucks but it’s better than buying a car…”, this is an example of sunk cost at work.

Logically, an economist would come to the conclusion that the brake pads need to be replaced for safety reasons.  Then they would look at the costs of this repair plus an estimate of potential future maintenance costs (totally ignoring any money that was previously spent) and deduce that it would actually be a better long term investment to just buy a different car – maybe one that isn’t 25 years old with 3 billion miles on it (for example).

But my friend’s brain  is playing Vulcan mind tricks on him because he is thinking back to the money spent on the original purchase, plus all the money he’s dumped in to his 80-year old rolling junkyard (plus the few grand he just spent 3 months ago fixing the shocks and right front tire which somehow blew for no apparent reason even though the tire was brand new).

So how is it that an outsider can clearly see that he should get rid of the car, but in practice he continues to dump money into it?

Why We Think Irrationally

Many people have a strong aversion to loss (wasting money). In examples like the one above, many people would feel obliged to continue using their car despite not really wanting to, because doing otherwise would be wasting the money already spent. In other words, they feel they’ve passed the point of no return.

Economists would label this behavior irrational because it misallocates money by using information that is irrelevant to the decision being made. This is also commonly referred to as “throwing good money after bad”, a concept that many of us are all too familiar with.

What About You?

Are you dragging your feet on implementing some much needed kitchen cabinet software at your dealership, rationalizing the sea of paperwork because of money you’ve already spent on some other system? Are you still pushing forward with a project with no light at the end of the tunnel because of the money involved to date?

The only way to really prevent losing money is to make decisions purely on the merits at hand – not on water under the bridge (I mean money under the bridge).

So next time you have a business decision to make, don’t let sunk cost creep into your decision making process. If you do, your business may end up just like my friend’s car — a not so fun ride which is incredibly expensive to keep moving.

Learn more about your financial metrics in this free eBook from BreakFront.