Archives

THE BUSINESS DESK

Business news from the Fredericksburg region.

Share
RSS feed of this blog

Don’t consider “sunk costs” when making decisions about future

A few weeks ago I was reading an article in The Washington Post titled, “Washington Redskins Roster May Face Significant Overhaul in Offseason.”

The article discusses, among other things, the future of RGIII at the Redskins. The article suggests that the Redskins have invested far too much money in RGIII not to keep him on the roster.

While this line of reasoning may make sense on the surface, it is actually incorrect from a rational decision making perspective. The money the Redskins have invested in RGIII is not coming back; rather, this money has already been spent and cannot be recovered.

To use a technical term, the money the Redskins have invested in RGIII is a sunk cost. Sunk costs are those costs that have occurred in the past and cannot be recovered. Like the money the Redskins have invested in RGIII, sunk costs are gone and you cannot get them back. Since the costs occurred in the past and cannot be retrieved, sunk costs should not be considered for future decisions.

Although sunk costs should not matter to future decisions, people still account for them. For example, whenever I cover sunk costs in my Principles of Accounting class at UMW, I like to ask students the following series of questions: “How many of you have ever been in a movie theater and five minutes into the movie know the movie will be terrible? How many of you would stay in the theater even though you cannot get your money back?”

From my experience, most students prefer to stay in the theater. I then ask my students why they would stay even though the ticket is non-refundable. Students commonly respond that they will stay because “they paid for the ticket.”

This is a great example of the sunk cost fallacy because the price paid for the ticket cannot be recovered. From a rational decision making perspective, the price of the ticket is a sunk cost and should not be considered for future decisions (i.e., staying or leaving the theater).

The reason why sunk costs should not be considered is because they are not differential costs. Decisions should be made based upon benefits and costs that differ between two alternatives; if a cost or benefit is the same in either alternative, then it should not be considered.

For instance, consider the movie ticket example again. If you stay in the theater, perhaps hoping that the movie will get better, you paid $10 for the movie ticket. Similarly, if you leave the theater, you still paid $10.00 for the movie ticket.

The price of the movie ticket is the same in either alternative and subsequently should not be considered in your decision to stay or leave the movie. Rather than accounting for sunk costs, decision makers should focus on comparing the future costs against the future benefits of one alternative over another.

For example, someone who is ten minutes into a lousy movie should compare the future benefits of continuing to stay in the movie against the future costs of staying in the movie.

One way to avoid the sunk cost fallacy is to focus on opportunity costs, rather than sunk costs. Opportunity costs are the benefits someone foregoes by choosing one alternative over another; for example, the salary someone would sacrifice by going to school full-time.

Referring back to the movie theater example, rather than focusing on the fact that you paid $10 for a movie ticket, and then perhaps staying in the theater because you paid for the ticket, focus on the all of the things you could be doing with your time rather than sitting through a lousy movie.

So, the next time you want to stay in a bad movie because you already paid for the ticket, or you feel the need to finish a terrible meal because it is paid for, try to avoid falling into the sunk cost fallacy. Instead, remember to focus on the future benefits and future costs of the alternatives involved in these decisions, rather than costs you have incurred in the past that you cannot get back.

This is one in a series of columns by University of Mary Washington College of Business faculty on various aspects of finance and economics as they affect our readers. Dave Henderson assistant professor of accounting and management information systems at UMW.

 

Post tags:

Permalink: http://news.fredericksburg.com/business/2014/01/12/dont-consider-sunk-costs-when-making-decisions-about-future/

*/