One of the greatest challenges in business is that you must take decisions based on incomplete information while being distracted by your emotions. Opportunity costs and the sunk cost fallacy are essential to master to navigate such a challenging decision-making environment.

Opportunity cost is the foregone benefit associated with deciding upon a particular course of action as compared to your other options. To put it simply, it is the benefit associated with opportunities which are no longer available to you after having decided upon another course of action. The lost gain associated with these missed opportunities cannot be ignored if you want to know the true cost of your selected option.

Imagine you have to choose between two different bookkeeping software options. One cost $25 a month and the other is free. A simple cost-based analysis, assuming that they can both generate the same output, would lead us to pick the free option over the paid version. However, this does not factor in the amount of time required by both systems to input in all the relevant financial data. If the free software requires eight hours a month of your time and the paid version only requires four, the true cost of each of the software options needs to factor in the value of the hours spent inputting data into the software, time which could be otherwise devoted to your business. If we ascribe the value of $30/h to each hour devoted to your business, the free software truly costs you $240/month whereas the paid version only costs you $145/month, meaning that once the opportunity cost is factored in, the paid version is in fact cheaper.

The sunk cost fallacy is the idea that we naturally factor in our previous investment in order to justify further investment. The issue is that we overvalue past investments and undervalue future investment when it should actually be the opposite since we now have the benefit of hindsight to judge the value of our previous investment. This is due to our natural inclination to avoid admitting that our past decisions were wrong which induces us to continue investing in this old idea even when it is no longer objectively the best course of action.

The sunk cost fallacy induces us to throw good money after bad when a better call would be to abandon the project and invest that additional capital elsewhere. Same as in poker when you need to be prepared to fold your hand even after having already bet quite a bit on it, thereby forgoing your previous “investment” on that hand, you need to be prepared to walk away for a bad business decision instead of investing more of your startup’s limited resources in it.

In this regard, one of my best business decisions was to pull the plug on a software development project. I had hired a software development company to prepare an integration to automatically follow up with customers of my tutoring business. The project was supposed to cost $2,000 and take a month to be completed. Six months later and after having already incurred more than $5,000 of development costs, the integration was still not working. I started having doubts about the calibre of the work completed which led me to discover that the developers had made some fundamental mistakes and that their code was overly complicated (which would require me to hire them again if I wanted any changes made in the future.) I brought my concerns up with their CEO who responded by promising to get the integration working and to fix the issues free of charge.

The sunk cost fallacy encouraged me to accept his offer due to the substantial money and time I had already invested in the project. Instead, I cancelled the project as I felt that even if the issues could be solved, the project was just going to keep on draining money in the future. The opportunity cost associated with this “free” offer was also substantial as it would ultimately result in additional development costs being incurred in the future whenever changes needed to be made. I determined it was cheaper to write off the entire initial investment than to further keep on financing the project. I then hacked a simple integration through Zapier which met around 70% of the project’s initial requirements without the substantial future trailing development costs.

So, keep your eyes open to catch non-factored in opportunity costs and the dangerous inducements to keep on throwing good money after bad through the sunk cost fallacy. Better to write off a little now than to double down on a bad decision and get your business deeper in the red. Best of luck!