Monday, February 13, 2012

Wrong Reason

A phrase commonly used in business is sunk cost. It refers to an expense that has been incurred, but cannot be recovered. You spend ten-million dollars on the development of a new product that is only two-thirds complete. You have no product to sell, so there's no way to recover the cost of development. The ten-million is a sunk cost.

Business schools teach you to never make decisions based on sunk costs; make decisions based on future (or prospective) costs. No matter how much you've spent getting to where you are, the question is how much will it cost to get where you want to be.

Make or Buy
You spend ten-million on development of a product that's just two-thirds complete. You have the opportunity to purchase another company with a completed product for three-million. Do you buy the other company and cancel your product development or continue? Since it will cost you another five-million to complete your product (you're only two-thirds complete), you make the purchase. The ten-million you've spent so far doesn't matter.

When looking at sunk-cost decision making from a purely economic perspective, it's easy to see the fallacy. Why would I spend five-million when I can get what I want for three-million.

In practice, it's a completely different story. Business people make sunk-cost decisions all the time. They place a higher priority on loyalty to a project than accountability to the business. They rewrite history to reduce past expenses attributable to the project under consideration. They develop plans that understate future-cost and overstate future-benefit. They make it a matter of pride (Look how far we've come!). They make it a matter of guilt (We've spent so much, we can't just quit.).

They equate 'sunk' with 'bad'.

Sunk ≠ Bad
A sunk-cost isn't a bad-cost, it's just an expense that you can't recover. For example, it could be that the company you purchase for three-million already spent twenty-million in development, but ran out of funds and couldn't continue to market. Your development costs weren't bad. At the time you began, developing the product rather than purchasing a company was the best choice.

However, since most people see sunk-costs as bad-costs and since most people don't like the potential side-effects (e.g., canceling a project that employs many), no matter how irrational it is (from a business perspective), they make sunk-cost decisions.

Sinking Costs
The opportunity to make sunk-cost decisions occurs ever day and not just in business. Sunk-costs are not limited to money nor to business. Every day you make investments. You invest your money... your time... your strength... your emotion... your passion... your ideas...

You invest in your partner... your kids... your home... your job... your education... your avocation... your religion... your favorite television shows... your favorite computer game.

It probably doesn't occur to you that everything you do is an investment of you into that activity, let alone that you should expect a return on that investment. Because of that, it's likely that most of your you-investment takes the form of sunk-costs.

All of this goes on without notice until it's time to make a decision. Suddenly, all the time, expense and effort you've put into something becomes crystal clear.

You can't quit school now, your father and I have worked so hard to get you into a good college.

We can't just sell the house, we've put so much into fixing it up.

I don't care that the other company has offered to double my salary, I've put fifteen years into this one and I just know that they'll eventually see what I'm worth.

I can't just leave him, I've worked so hard on our relationship.


These are all forms of sunk-cost decision-making. The enormity of your investment causes you to lose sight of where you want to go. Not being clear on where you want to go, makes it impossible to see the least expensive (emotionally, physically, financially, temporally) way to get there.

By happenstance, sunk-cost decisions can turn out just fine, but the reasoning is always wrong.

 Good Reason
Stay in school?You love what you're studying and want to make a go of it.
Keep the house?It's the best place for you and your family to be.
Don't quit? You're passionate about the work, enjoy the people and are compensated well.

What sunk-cost decisions did you make yesterday? What sunk-cost decisions await you this morning?

Happy Monday,
Teflon

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