Sunday, September 08, 2019

Escalation of Commitment (Or Why You Should Ignore Sunk Costs)

Escalation of commitment (or why you should ignore sunk costs)
Escalation of commitment is a human behavior pattern in which an individual or group facing increasingly negative outcomes from a decision, action, or investment nevertheless continues the behavior instead of altering course.

People maintain behaviors that are irrational, but align with previous decisions and actions.

Economists and behavioral scientists use a related term, sunk-cost fallacy, to describe the justification of increased investment of money or effort in a decision, based on the cumulative prior investment ("sunk cost") despite new evidence suggesting that the future cost of continuing the behavior outweighs the expected benefit.

This is probably the most important decision-making rule you learn in business school, yet it is still largely misunderstood in the real world.

When making a choice between two options, it's imperative that you only consider what’s going to happen in the future, not which investments you’ve made in the past. The past investments are over, lost, gone forever. They are irrelevant to the future.

For example, say you have two office buildings. One you've bought for $1 million, and one for $10 million. You want to move all your people into one of these buildings. Which one should you pick?

I know. The one that’s right next to the railway station and has enough parking space, not the one in the city center that is so hard to reach. Does it matter how much the office cost to buy? No. Not at all.

Now imagine you and your team have worked for months on a deal to buy another company. They were really hard to work with. You spent countless hours analyzing, reviewing, and negotiating contracts.

On your way to the lawyer's office to sign the deal, another company calls you and offers you double the amount to buy the other company from you. Should you sell?

The answer is yes. The amount of time you spent getting the deal is irrelevant. If you wouldn’t be willing to PAY double for this company (and you weren’t, or you would have) then you should be willing to SELL it immediately. Spend some money on a party for the team and go find a new and better deal for your company.

Or say you make a mistake and keep the company instead of selling (the company cost you double now). Down the road, the deal turns out not to bring you the benefits you expected. You don’t like them so much now. But you paid double for the deal! Should you keep the company, or sell?

What do you think?

The business world is fraught with examples of escalated commitment that could have—and should have—been avoided, resulting in unnecessary losses. Just because the team spent a lot on the new ERP system doesn’t mean they shouldn’t spend more to make it actually work. The amount they already spent is irrelevant. What matters is what the benefit of a properly working ERP system will be.

In a nutshell: You should ignore sunk costs in any decision making.
Posted on Sunday, September 08, 2019 by Henrico Dolfing