Monday Mornings with Madison

Decision-Making and the Sunk Cost Fallacy, Part 1

Word Count: 1,719
Estimated Read Time: 6 ½ min.

Standing by a Bad Decision

Your company’s leadership made a decision to open a new division or expand into a new territory. Or, the VP of Product Development decided to launch a new product or service.  Or, the COO decided to shift a fundamental process in the company from one department to another.  Or, the CTO made a decision to upgrade to a new software.  Or, VP of Business Development hired staff to try a new sales approach.   Or the business owner hired a new CEO to run the company. These are all major decisions, not made lightly or casually.

In any of these situations, a great deal of time is spent analyzing and discussing whether a big move makes sense and even more money is expended implementing the idea.  These are not spur-of-the-moment, off-the-cuff decisions. In mid-sized to large companies, these decisions are carefully studied and considered by a team that includes a business analyst, marketing guru, sales expert, legal counsel, an HR director and a few number crunchers.  In global organizations, such decisions are engineered by teams that not only include all of the aforementioned top leadership but also a powerhouse law firm, a management consultant, a big four accounting firm, a Madison Avenue ad agency, and a highly connected media firm.  Nothing is left to chance.

Then, the division, office, project, program, product, or service rolls out or the person is hired. And, despite taking every precaution to ensure success, the results are less than stellar.  Things go wrong.  The expansion sputters.  The new division fails to generate enough revenue.  The new service is not embraced.  The new hire does not deliver the expected results.  The new software is so complicated it cannot be integrated into the operation.  It becomes increasingly clear with every passing day that the decision – supported and embraced by one, several or many – was a bad one.   But, no one pulls the plug and reverses course.  Why?

Understanding Sunk Costs

A sunk cost is one that has already occurred and cannot be recovered by any means.  In accounting terminology, a sunk cost is also referred to as a past cost, embedded cost, prior year cost, stranded cost, sunk capital, or retrospective cost.  Sunk costs are fixed.  While all sunk costs are fixed, not all fixed costs are sunk costs.  Equipment and property, which are fixed costs, can be resold at a determined price.  Therefore, some fixed costs are not sunk costs.

Sunk costs are just as the name implies… sunk.  That time and/or money has been spent.  It’s a done deal.  There is no reversing that, which is precisely the problem.  Sunk costs are independent of any event and shouldn’t be considered when making investment or business decisions.  Only relevant costs should be factored when making decisions.  Those are the costs related to a specific decision and that will change depending on the decision.  However, time and again, emotions and information related to past decisions – the sunk costs — are taken into account when making future decisions.  It goes something like this:  “I spent X dollars to open that store.  I don’t want it to be a total loss, so I will keep trying to make that location successful.”  Or “We spent X thousands of man hours to develop this new product.  It hasn’t generated enough of a return to break even yet, so we will keep pushing the product in hopes that we can at least recoup the R&D cost.”  This is the sunk cost fallacy.   The sunk cost fallacy is the pursuit of an inferior option merely because the person previously invested significant, but unrecoverable, resources in it. This flies in the face of rational decision-making, but it happens all the time.

Christopher Olivola, an Assistant Professor of Marketing at Carnegie Mellon’s Tepper School of Business, conducted a series of experiments on this phenomena and published the results last year in Psychological Sciencejournal. Olivola conducted eight experiments. According to Olivola, “The sunk cost effect is the general tendency for people to continue an endeavor, or continue consuming or pursuing an option, simply because they’ve invested time or money or some resource in it.”[1] But, he found that not only does the sunk-cost effect happen in purely intrapersonal situations (i.e., decisions driven by a person’s own past investments), it also happens in interpersonal situations (i.e., people will alter their choices in response to other people’s past investments).   Covering diverse scenarios, he found that the sunk-cost effect occurred when the costs were borne by someone other than the decision-maker. Moreover, the interpersonal sunk-cost effect was not moderated by social closeness or whether other people observed their sunk costs being honored.  Therefore, the phenomena is much more wide-spread and pervasive than previously believed.  It happens a lot.

The sunk cost effect applies not only to investment of money, but also time.  It also applies to all kinds of decisions, including business and personal.  The longer a person has been in a relationship, the harder it is to end that relationship.  The longer a person has been employed by a company, the harder it is for the leadership to terminate that employee.  The longer a company keeps a product in production, the harder it is to stop producing that product.

A clear example of the sunk cost effect with production of a product was seen with GM’s manufacturing of large vehicles.  In the early 2000s, General Motors made the decision to continue manufacturing large vehicles when the market had just started trending toward more fuel-efficient and hybrid cars.  It was a decision based on the company’s past experience and emotional investment rather than market trends and data.   In 2009, that bad decision nearly cost GM its existence and forced it to file for bankruptcy.  It was only thanks to a government bailout that GM was able to survive that bad decision.  By 2017, GM had announced that it  planned to launch 20 all-electric, emission-free vehicles in China by 2023.[2] By finally recognizing the sunk cost trap, the company’s leadership made a significant reversal on that bad decision. GM was fortunate.  Few companies live to see another decade and remain on the Fortune 500 list after that kind of decision.

One needn’t venture too far from GM to find another company that also fell prey to the sunk cost effect, and long before GM did.  In 1972, Firestone began manufacturing radial tires to lengthen the life of their product.  They used a new technique to get their tires to market ahead of competitors.  That year, after they began production, Firestone found that the rubber came off the wire when the tire was in use.[3] This was well documented and understood by the leadership.  Rather than stop production and rectify the problem right then, Firestone continued manufacturing the faulty tires through the 1970s to satisfy demand.  By 1978, though, pressure from the government and concern about safety from consumer advocacy groups forced Firestone to recall approximately 10 million tires.  What was worse, Firestone blamed tire failure initially on substandard maintenance of the product by the consumer.  However, a 1980 NHTSA study revealed that Firestone was actually aware of the defective products practically since its inception and did nothing to fix it.  This was a huge breach of trust and led to massive lawsuits and terrible publicity, hurting earnings and sales so badly that stock prices dropped to a low of $6.25 per share.  (At its peak in 1969, Firestone shares traded at $33.25 per share.)  The stock price never completely rebounded in the 1980s and Firestone was eventually acquired by Bridgestone in 1988.  Clearly, Firestone’s leadership fell victim to the sunk cost fallacy.  They doubled down on a bad decision instead of recognizing it early and changing course.  The irony is that a decade later, Bridgestone/Firestone fell prey to the same sunk cost fallacy leading to yet another tire recall by NHTSA in 2000.  So, the inability to spot bad decisions can be a recurring problem for businesses who do not recognize the issue.

Yet another example of the sunk cost effect decimating a major organization happened at Kodak.  In 1955, Eastman Kodak was ranked 43 on the Fortune 500 list.  It was a powerful company, with shares peaking at $94 in 1997.   And, Kodak was a leader in research and development, owning the patent for digital cameras since 1975.  However, because of their emotional and brand connection to film and their inability to look at the market data dispassionately, Kodak chose not to pursue development of digital cameras.  They were worried about it undercutting their film business into which they had already invested decades of time and money.  It was faulty decision-making based on the sunk cost. It wasn’t until the mid-1990s, after the popularity of film cameras began to decline, that Kodak finally pushed into the digital camera market.  By then, Fuji and Sony had control of the market.  As a result, Kodak was never able to capitalize on a product it actually invented.  Even when it finally assumed the #2 spot in digital camera sales worldwide, it was losing $60 on each camera sold.  The final nail on the coffin was the advent of cameras on smartphones and tablets.  By 2011, about 15 years after its poor decision, the stock dropped to $.65 per share.  Eastman Kodak filed for bankruptcy in December 2011.  The company did not go under, but today Kodak shares trade at $2.42.  It is doubtful that Kodak will ever return to the Fortune 500 list.

The decision-maker digs in to a decision deeper – escalation of commitment – because of the time and money invested, the sunk cost fallacy.  In doing so, he digs a deeper and deeper hole.  In gambling parlance, this is known as doubling down on a bad bet.  This management problem is not limited to car and camera manufacturers or to any particular industry or type of person. It occurs in businesses within all industries and sectors, and to all kinds of decision-makers.  Male and female.  Young and old.  Novice and experienced.  So why does it happen and how does a business owner or manager keep from falling prey to this insidious thinking error?  Stay tuned to next week when we explore why the sunk cost fallacy occurs and how to keep it from happening to you.

 

Quote of the Week

“The fear of the possibility of losses is a stronger motivator than the likelihood of gains.” Dr. Daniel Kahneman


[1] July 1, 2018, Olivola, Christopher, Tepper School of Business, Carnegie Mellon University, TheInterpersonal Sunk Cost Effect, Journal of Psychological Science, Volume: 29, Issue: 7, Pgs. 1072-1083.

[2] October 2, 2017, Welch, David, GM Plans 20 All-Electric Vehicles by 2023, Bloomberg, Technology,  https://www.bloomberg.com/news/articles/2017-10-02/gm-pledges-electric-future-with-20-all-electric-models-by-2023

[3] September 17, 2000, Mendenhall, Deborah, Firestone woes reminiscent of massive tire recall of 1978-80 Old Post Gazette, http://old.post-gazette.com/businessnews/20000917tires1.asp

 

© 2019, Written by Keren Peters-Atkinson, CMO, Madison Commercial Real Estate Services. All rights reserved.

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