CUTTING YOUR LOSSES: HOW TO AVOID THE SUNK COST TRAP

turnstile-fail

“If at first you don’t succeed, give up,” is the road less travelled for leaders who continue to spend money on an acquisition they made – even though the acquisition is clearly not working out. But why, as this author asks, don’t we actually strive to create an organizational climate that makes admitting and learning from mistakes as valued as persistence and perseverance? Below, he describes four steps that can make it easy for leaders to cut their losses and save face.

In a highly volatile world, leaders cannot keep marching in the same direction simply because they have invested heavily in a particular course of action. Instead, leaders must react to changing conditions and be willing to shift direction accordingly, perhaps even to pivot one hundred eighty degrees if the situation warrants it. In a turbulent environment, leaders must gather feedback from multiple voices and assess progress against their original goals and objectives on a regular basis. As negative feedback emerges, or external conditions change, successful leaders learn and adapt. Unfortunately, far too many leaders stick to outdated strategies for far too long. Why do they fail to adapt? In part, many leaders do not want to “waste” the time and money that they have already spent. Thus, they keep plowing ahead despite all the changes taking place in their environment. Economist Richard Lipsey and his colleagues have described how people often have a hard time “letting bygones be bygones”:

Individuals and companies should make decisions based on the marginal costs and benefits of their actions. If an activity yields positive net incremental benefits, then one should choose to pursue that course of action. The amount of any previous irreversible investment in that activity ought to not affect the decision that is being made. Prior investments, which cannot be recovered, represent sunk costs which should not be relevant.

Unfortunately, most people and organizations often do consider past investment decisions when choosing how to move forward. In particular, individuals tend to continue to engage in activities in which they have made prior investments. Often, they become overly committed to certain activities despite consistently poor results. As a result, individuals make additional investments in the hopes of achieving a successful turnaround. Rather than cutting their losses and changing course, they “throw good money after bad.” In the face of high sunk costs, people often escalate their commitment to failing courses of action.

 

Why do we fail to ignore sunk costs?

Psychologists do not know for certain why we have a hard time ignoring sunk costs, but they have proposed a few possible explanations. First, they have shown that the framing of a decision affects an individual’s attitudes towards risk. Individuals demonstrate risk aversion with regard to choices framed as potential gains. On the other hand, they exhibit risk-seeking behavior with respect to losses. If an individual makes a prior investment decision which yields poor results, they often view subsequent decisions as opportunities to turn around past failures. Meanwhile, individuals see the decision to invest no further as a sure loss. When individuals consider aborting a particular activity, they view past investments as wasted resources. This aversion to wasting money leads individuals to continue investing in a particular activity in hopes of utilizing, rather than wasting, their prior investments. Therefore, individuals may pursue risky investment opportunities, perhaps “throwing good money after bad.”

Another explanation focuses on the cognitive dissonance that occurs when we observe negative results after making a decision that we thought would be highly beneficial for the organization. Psychologists have shown that people rationalize past actions when faced with evidence that contradicts prior choices. This rationalization, or self-justification, may lead people to commit further resources to a particular course of action despite poor results. The further commitment of funds provides an opportunity to resolve the individual’s dissonance. By investing additional dollars, individuals can sustain the belief that these funds may turn around the situation and validate their initial investment decision.

Cognitive dissonance also leads individuals to analyze information in a biased manner. Experimental studies demonstrate that individuals place heavier emphasis on data which supports their initial position, while discounting discordant information. This means that decision makers may continue to pursue an unprofitable course of action, because they systematically emphasize any positive results, while disregarding negative feedback.

Making highly visible, public commitments to a course of action has powerful psychological effects as well. Individuals infer a strong sense of responsibility from the consideration and observation of their past actions. As a result, they become reluctant to change their position. They hold fast even in the face of negative feedback or social opposition. This explanation appears to apply to investment behavior, particularly acquisitions, since these managerial activities attract significant public attention. This highly visible, public commitment that takes place when a merger is announced may bind executives to that course of action. Indeed, in a study of corporate divestitures, University of Illinois finance professor Michael Weisbach found that entrenched managers will hold onto business units which they acquired, while new CEOs are more likely to divest divisions that are struggling. The new CEOs, of course, are not weighed down by the burden of sunk costs.

Finally, organizational culture may encourage the sunk-cost effect. Individuals in certain cultures may value persistence and perseverance. We often hear corporate leaders exhort their people to demonstrate a “can-do, never give up” attitude. As a result, unfortunately, individuals may stick to unprofitable courses of action in adhering to these values. These cultures may also discourage people from readily admitting mistakes. People may not cut their losses out of fear of being blamed for the failure and perhaps being fired.

Fighting the urge to throw good money after bad

We have established that people have a hard time cutting their losses, yet most studies offer little prescriptive advice for how to avoid the sunk-cost trap. Over the past few years, many executives across a wide range of industries have shared their ideas with me as to how they steer clear of this trap, acknowledge their mistakes, and move ahead on a new path when changing conditions warrant it. Let’s review the four main strategies that they employ.

1. Launching the pre-emptive conversation

Leaders need to consider how they set the stage for the difficult conversation that will eventually take place if an organization must admit failure, cut its losses, and abandon a project. David Breashears, the highly accomplished climber and Emmy Award-winning filmmaker, has demonstrated the capacity to make the difficult decision to turn around high up on a mountain. Of course, the sunk-cost effect can be a powerful and dangerous influence on decision-making as one approaches the peak. Summit fever kicks in for many climbers. They have invested so much and come so far; they cannot turn back when the goal appears so close.

In May 1996, while many climbers continued on their way to the summit of Mount Everest, only to encounter a dangerous blizzard, Breashears and his team turned around and headed back to Base Camp. They survived, while a number of their fellow climbers on other expeditions died during the storm. Breashears acknowledges that one could feel a bit ashamed heading down the mountain while others courageously plowed forward. After all, we tend to admire those adventurers and explorers who show grit, determination, and perseverance rather than celebrate those who abandon a mission out of concern for personal safety. However, Breashears reminds us that a leader must remember that they are responsible for an entire team’s safety. One cannot let pride and emotion cloud personal judgment.

Breashears points out, however, that one must prepare carefully for that conversation about abandoning a mission and turning back. You cannot have the discussion with your team for the first time while staring at the summit. Instead, an effective leader brings the team together long before setting out on the expedition. Prior to meeting with the team, the leader envisions a multitude of scenarios in which things go dramatically wrong, and he or she thinks through how and why the initial plan might have to be abandoned in favor of a quite different course of action. Breashears argues that leaders must then have an in-depth conversation with team members about these scenarios. Teams must make decisions about the types of situations that would require them to cut their losses and reverse course. According to Breashears, teams ought to have these conversations before they have incurred sizeable sunk costs. In other words, think through the scenario when you can still think clearly, without sunk costs clouding your judgment (not to mention thin air in David’s case!).

2. Creating constructive tension

In some organizations, leaders have chosen to institutionalize an element of constructive tension in the management structure of projects to protect against the sunk-cost effect. They have insured that a natural tension exists between people who occupy different positions within the firm. Consider, for example, how Electronic Arts, a market leader in the video game industry, managed the product development process for many years. Most of its rivals appointed one person with total responsibility for overseeing the design of a new game. Electronic Arts created two separate leadership roles. Each person maintained distinct areas of accountability. The producer focused on product quality, building a creative game that can be enjoyable for consumers to play. The development director tried to come in under budget and on schedule. One senior executive described the purpose of this unique structure to me several years ago:

We have created a system of checks and balances or creative conflict. The producer focuses on ensuring that the game design is the best… The development director focuses on project management, budget, schedule, on-time delivery, etc. And they clash. We force that conflict and that discussion so that the team will push the envelope.”

Why did Electronic Arts strive for such creative conflict? Developing a video game can be a very expensive proposition. As many video game executives point out, designing a good game costs just as much as creating a bad game. Once a game is complete and taken to market, a company needs to sell a very large number of copies just to break even. A few games become blockbuster hits and achieve high profitability; many products never recoup their high fixed investment. To succeed, video game companies need to assess projects at a variety of intermediate points and be willing to kill projects that have veered off track. They cannot let the sunk cost effect overwhelm them. CEO John Riccitiello described the firm’s philosophy: “The smiley-face approach to management doesn’t work in entertainment. Some people hope and dream and pray that spending more money and time will work. We double down on things that work. We tend to stop things that don’t work.”ii

Other companies employ a slightly different approach. For instance, one insurance company’s information technology executives reported that they assigned an unbiased outsider to help project teams evaluate their progress at a set of pre-determined milestones. The outsider might be an external consultant, but often times, he or she simply worked in another unit in the firm. Executives pointed out that this process worked most effectively when teams established a clear set of milestones and metrics at the outset of the project. Therefore, the unbiased outsider could employ relatively objective and mutually agreed-upon criteria for evaluating whether the team should continue forward. Executives also stressed that the unbiased outsider should be someone with substantial status within the organization. That status tended to insure that the outsider would be willing to speak candidly, and that the project team would be unlikely to dismiss their feedback and concerns.

3. Actualize assumptions, generate alternatives

Many firms report that the decision-making process must involve a concerted effort to make key assumptions explicit, and then to test those assumptions. As one executive at a large retailer informed me, organizational leaders must ask their teams: “What must be true for us to conclude that we can turn around this failing project? What are we assuming about our capabilities, our customers, etc.? Are these assumptions valid?” Often, making these assumptions explicit exposes the improbability of a successful turnaround. Allowing key presumptions to remain below the surface and untested makes it much easier to throw good money after bad.

To make more effective decisions in these circumstances, leaders will find it helpful to generate multiple alternatives. Too often, we frame choices as “go or no go decisions” rather than outline an array of options. “Go or no go” scenarios do not represent multiple alternatives; they are simply two sides of the same coin. Too often, we use language in our deliberations and discussions that exacerbates the sunk-cost effect. You hear people talking about a decision to “stay the course” versus “cut and run.” Who would choose the latter option? Cutting losses makes one feel like a coward when the decision is framed in this manner. Leaders must help their teams consider a variety of different paths for moving forward, and they must be aware of the language used to frame each alternative.

When comparing multiple options, the assumptions prove critical. We have to flush out the beliefs that people hold and be ready to question them. Harvard strategic management professor Jan Rivkin has described an important shift in mindset that must take place for an executive to actualize assumptions and evaluate multiple options effectively. He argues that we have to challenge people to define “what would have to be true” for one option to be chosen over another. As Rivkin writes, “The shift in mindset from ‘What do I believe?’ to ‘What would I have to believe?’ is a major, and often difficult, one.”iii

4. Defining opportunity costs

Finally, leaders must help their teams consider the opportunity costs of staying the course. Often, we only consider the tangible financial costs and benefits of continuing on a particular path. On top of that, we weigh the sunk costs inappropriately, yet we fail to evaluate our opportunity costs. By sticking to a previously chosen path, an organization naturally forsakes other possible uses for its physical, financial, and human resources. Teams can find it eye-opening to have an explicit discussion about the potential paths that must be forsaken if one plows ahead with a particular project.

Consider a company that must grapple with a decision to divest a struggling business unit, a choice that I observed one management team consider recently. Imagine the conversation if the team tried to assess the opportunity costs of continuing the turnaround effort. Consider the questions that could be asked: What could we do with the talented people that we are deploying to manage the integration and execute the turnaround? How might we redirect top management’s attention if we divested this unit, and what impact would that have on the business? What alternative uses might exist for the physical and financial assets that we plan to utilize to save this unit? Note that these questions help a team recognize that opportunity costs are not strictly financial in nature; they also involve time, talent, and attention.

Admiring persistence

Persistence can be a valuable leadership quality, perhaps even more so in a volatile environment. Sometimes, we want our leaders to push through obstacles; no one likes a quitter, as they say. However, we must be concerned if someone ignores all the advice and evidence to the contrary and continues to throw good money after bad. We certainly should be wary if an individual or a team appears to have a track record indicating a reluctance to cut their losses when projects go south. In sum, in a volatile world, perhaps we must question the extent to which our organizational cultures emphasize the value of perseverance. How much value do we destroy by making people feel as though reversing direction and cutting losses are things about which we should be ashamed? Should we not strive to create an organizational climate that makes admitting and learning from mistakes as valued as persistence and perseverance?

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