Sunk Costs

Occasionally we run into customers who are reluctant to use Disco because they have large sunk costs in the software they currently use.  While people are free to make decisions based on whatever criteria they choose, we think that particular analysis is not correct.

A sunk cost is a cost that has already been incurred and cannot be recovered. Compare that with a prospective cost, which is a cost that might be incurred when a decision is made.  Economic theory states that people should consider prospective costs but should not let sunk costs influence decisions because doing so does not allow for making a decision exclusively on the merits. However, sunk costs greatly affect many people’s decisions because they don’t want to “lose” the money they have already spent. This is the sunk cost fallacy.

The sunk cost fallacy is often seen in a reluctance to abandon projects in which a person has already invested considerable resources. People want a good return on their investments and have a genuine interest in making their efforts worthwhile. People also tend to hold on to an investment despite evidence that the investment will not produce the returns they had hoped.  No one wants to feel that they wasted time or money.  

The key to avoiding the sunk cost fallacy is to remove any past investment from the decision making calculus.  Since the costs have been incurred and cannot be recovered, they should simply not be considered at all in making future decisions.

Let’s take an e-discovery software to illustrate the point.  Let’s say Company X has been marketing review software for one year and is presented the opportunity to sell Disco at the end of that first year.  Chances are that Company X had to pay a yearly license fee for its current review software.  It likely had a yearly fee to license the software it used to process the data for loading into the review software.  It also likely paid 2-3 employees to run the processing software.  Hypothetically, if the review license costs $10,000/year, the processing license costs $15,000/year, and the employees are paid $25,000/year each, Company X had costs of $75,000-$100,000.  The company has also likely invested significant resources hiring salespeople to sell the review software and training people how to use it.  This is in addition to the per gigabyte fee for storage in the review platform.  Those are sunk costs that cannot be recovered.   These same costs are also prospective costs for year two for the incumbent review platform, costs which Disco does not have.

It’s easy to see why Company X might feel tied to the software package it currently offers. However, the correct economic analysis is to ask which software will make the most money in the future (including evaluating prospective costs), and not to think about how much has already been spent.  When the company applies the correct economic analysis, however, we think the correct decision becomes clear. 

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