Sunk Costs and Loss Aversion

Sunk costs are usually defined as previously incurred costs that are not recoverable and should not be taken into account in decision making. Here is a slightly modified example of a sunk cost from Jerold Zimmerman's "Accounting for Decision Making and Control" (Irwin McGraw-Hill):

Example. Abadabba Berman, the comptroller of the Schultz Cement Shoe Company, has contracted with Microstiff to design a proprietary accounting software package for the company at a cost of $15,000. After months of dealing with countless glitches and bugs the system just barely works. Finally one of the frustrated bookkeepers points out to Abadabba that for only $2,000 they could purchase an off the shelf package from Quickcrooks that would generate all the reports that the more expensive system provides with a fraction of the aggravations and crashes. Abadabba cannot bring himself to invest the additional $2,000 in the replacement system even though the company will easily save that much and more in the improved productivity of the accounting department. Abaddaba reasons that they have too much invested in the old accounting system to simply abandon it.

Abaddaba should consider the past investment in the expensive Microstiff software a sunk cost. He should ignore the past investment in deciding whether to abandon the software and replace it with the Quickcrooks package. According to cost accounting theory the only relevant costs to consider are the future costs associated with each option. If retaining the Microstiff software is more expensive going forward than buying the Quickcrooks package then the Microstiff software should be abandoned. The previous heavy investment in Microstiff should not be a consideration in making his decision.

Loss Aversion: Why Abaddaba Won't Let Go of Microstiff

According to cost accounting theory Abaddaba's choice to hold on to Microstiff is irrational. The best choice for the company is to abandon the software, not keep it. Now of course, the irrational choice for the company may be a very rational choice for Abaddaba personally. Why? Because the boss of the company, Dutch Schultz, has a notoriously bad temper and Abaddaba does not want to face Dutch's wrath when he tells him that he made a $15,000 mistake going with Microstiff. So from Abaddaba's perspective it is rational to cover his rear and stick with the bad software.

But this is not really the full story because even if Abaddaba was the owner of the firm the odds are that he would still make the irrational choice to stick with the crummy software. Why? Because he, like all of us, tends to be very reluctant to accept losses. Abaddaba's failure to treat the prior investment as irrelevant is a species of a very common behavioral trait known as loss avoidance.

Varieties of Loss Aversion

For most people losses loom larger than gains. The pain we feel from a loss generally outweighs the pleasure we feel from a comparable gain. This is what the social scientists term loss aversion. Variations of loss aversions are common place in business and investing. For example, investors are, as a rule, much quicker to realize gains than losses. This is the reason why automatic stop loss orders are implemented when buying stock. An automatic stop loss triggers a sale when a stock investment's price drops to a certain point. It is automatic and commonly used because it is the all too human trait of loss aversion that often keeps people from cutting their losses. The tendency is for people to hold on to losers in the hopes that the loss will reverse.

Real World Decisions

In the above example all the consequences of the different courses of action were specified. I told you what the dollar consequences of keeping the old software versus buying new software would be. Rarely in real world situations do we have precise dollar estimates for the results of different courses of action. The tendency to stick with losers, and thus not cut our losses, can be reinforced by the ambiguity surrounding real world decisions. If you are in a position of being emotionally invested in a bad decision, the tendency will be for you to filter out and skew data that would support abandoning the course of action you are invested in.

Practical Advice on Dealing with Sunk Costs and Loss Aversion

First recognize that there is no way to detach yourself emotionally from the consequences of important decisions that you have made. Recognizing that you have made a poor important decision is always going to be painful. What you can do is recognize that you have an emotional investment in your decisions and seek the advice of individuals who are not so emotionally invested. These individuals are less likely to filter out information that might call for abandoning a bad investment.

So who can you consult with about important decisions? If you are a small business owner it is important to have an outside advisor. Outside accountants, Small Business Extension Center staff, or volunteers from S.C.O.R.E are all good possibilities that will not break your budget. Trade or business associations often have staff available for advice on business operations. Also do not overlook the web as a possible resource of good advice. Almost every type of industry or business has forums where similarly situated owners can offer each other advice.

For larger businesses, independent boards of directors can fulfill the role of detached advisors as well as outside consulting specialists. Also remember loss aversion and the unwillingness to abandon sunk costs can exhibit itself in groups as well as individuals.

Finally, do not forget that even the smartest people make mistakes and often very big ones. Ignoring non-recoverable costs requires admitting that we have made bad decisions. Never an easy thing to do. But the ability to admit mistakes, abandon sunk costs and move on is vital to success in any enterprise.

About The Author-- Michael Sack Elmaleh is a Certified Public Accountant and Certified Valuation Analyst. His book, "Financial Accounting: A Mercifully Brief Introduction", has received wide critical acclaim. He has nearly 30 years of accounting and 10 years of teaching experience.His web site is understand-accounting.net

Article Source: Articles island - Free article submission and free reprint articles