In times of trouble, sunk cost. How to make decisions looking ahead
There are many traps that our minds face when making a decision. There are many biases that divert our reasoning, leading us to make decisions with little clarity and sometimes obtaining dreadful results. However, one of these biases is perhaps the one that has the greatest impact on the results of our decisions, and often the one responsible for our decisions failing completely: the sunk cost bias.
Considering what it cost me, I’d better enjoy it.
It is known that the costs of the past should not be taken into account for our future decisions. However, it seems that it is not entirely easy to avoid falling into some type of reasoning bias in this regard.
Suppose you find yourself in the following situation: several minutes ago, when you arrived at the bank, you had to choose between row A and row B, both with ten people waiting. Suppose you chose row A. Now, after thirty long minutes, you notice that in front of you in row A there are still two people, while in row B there is only one. What do you do? Do you change lines? Why is it not so easy for us to move to row B? A phrase like, “I already wasted thirty minutes, now I’m staying.” could explain it.
It would seem that even though we know that the costs incurred in the past -or time, in the case of bank lines- should not be considered in our decisions, they nonetheless condition us in some unreasonable way, altering and modifying our preferences at the moment of deciding. Otherwise, why do we stay up watching until the end of a movie that we know is boring? Why, if something cost us more money or more effort, do we take care of it or value it more? “Considering what it cost me, I’d better enjoy it.”, someone might think.
It is often observed that people fall into the sunk cost bias, adopting behaviors that end up generating greater losses by not recognizing a cost previously made. The costs of past decisions, if not recognized as such, could drastically alter our preferences about a decision to be made. Of course, the practice in the detection of this type of mental bias prepares certain decision makers to make a personal and business decision in a clearer way, and not contaminated with irrelevant information.
It is common to hear from an investor, comments of the type: “Since I bought it when it was trading at 40, and now it’s trading at 30, I’d better wait for it to go up again so as not to lose 10. If I close the position now, I’ll lose money”. The evaluation of investments does not seem to be exempt from the sunk cost bias.
In times of profound structural changes in market and business dynamics, it is essential to be able to clear our minds of the burdens of the past in order to make decisions freely, only thinking about the future of our business.
The costs or efforts already invested in the past of a project cannot, under any point of view, be considered in investment decisions, of course, thought towards the future. Sunk costs are those costs that cannot be recovered and therefore will not alter the results of the decision to be made. However, in business settings, seasoned executives cannot easily shake off this bias. “After so much effort, we’re going to cancel the project?” Even though the decision is obvious, when faced with such a decision, non-monetary sunk costs may wrongly impact our decision-making clarity.
Precautions in the use of ROI and ROCE
When evaluating an investment project, we resort to the help of indicators that allow us to understand the characteristics and the convenience or otherwise of said investment. One of the most frequently used indicators is ROI (Return on Investment), and one of its variants is ROCE (Return on Capital Employed). In both cases, the ratio or weight of the results over the investment or the capital employed is calculated. But be careful here: these indicators are only valid if the capital has not yet been used or if the investment has not been made.
Performance appraisal could bias decisions
Sunk costs are those that cannot be recovered and therefore will not alter the results of the decision to be made.
Performance evaluations of a company employee could sometimes foster the sunk cost bias and thus lead to making incorrect decisions. Let’s look at an example: An employee, responsible for a project, is evaluated by the ROI of that project to be calculated at the end of the year.
Let’s also assume that the investment in this project has already been made almost completely; say 95%. If the project now had very little chance of being profitable, would the employee decide to invest the remaining 5% as long as there is some probability, even minimal, of recovering what was invested? Probably yes.
By subtracting (proportionately) such a small amount, the person responsible for the project’s result might prefer to risk this (proportionately low) amount in order not to face a bad evaluation at the end of the year with certainty. Since the employee will be accountable for the full amount invested, their decision will most likely be biased by sunk costs, not necessarily making the best decision for the business.
Committed future costs are also sunk
It is perhaps clearer to associate sunk costs with sunk past costs. However, those costs that have not yet been realized but are already irrevocably committed should also be considered as sunk costs; and therefore, should not be taken into account for decision making.
A rent to pay, whose contract does not have a termination clause, or the cost of labor, if the company does not have in mind to reduce the staff, are also clearly sunk costs and should not be considered when deciding. In the latter case, the characterization of labor as a variable cost could lead to confusion, but this characterization has nothing to do with decision making. The sunk cost is then defined as a sunk cost that does not vary between the alternatives of a decision, whether this cost is incurred or irrevocably committed.
The bad results of our past decisions should not harm our future decisions. If we invested time or money in a way that didn’t turn out as expected, do not punish our next decision for it. The good decision maker must recognize the losses of past decisions as soon as possible and try to free their mind from the burden that could cause them. Regretting a bad decision in time, acknowledging a loss, announcing a write-off, or declaring obsolescence as soon as possible are healthy practices for a decision-maker trying to avoid falling into a sunk cost.
Recognizing a sunk cost can be difficult. Not letting yourself fall into its effects can be much more so. Being attentive to its consequences and questioning ourselves on each occasion if the evaluation of the alternatives is free of this type of bias, may be the first step towards a clear decision. If you ever hear yourself saying, “Considering what it cost me, I’d better enjoy it.”, “After so much effort, now let’s finish it.”, or some similar phrase, be aware that you are falling deep into the sunk cost bias.
Partner at Tandem.