Finance -- Rising Above Sunk Costs

Dec. 21, 2004
Focus on what's best for your company's future.

The name is arcane. But if you've ever shelled out major dollars for auto repairs only to discover that you would have been better off buying a new car, you're acquainted with sunk costs. Quite simply, it's money you've spent and can't recoup. In the corporate world, sunk costs are in play in a big way when you're agonizing over whether to continue to invest in a money-losing project or shut it down. Or when you're torn between walking away from existing, highly usable production equipment and investing in newer, faster, more efficient machines. As a general rule, shutting the project down or walking away from the old machines is exactly what you should do. Investments should be based strictly on the course of action that promises the highest future rate of return. But it's not easy to ignore the money you've already sunk into the project or production equipment. You probably feel responsible for the money you've already spent, says Daphne Main, an associate professor at the University of New Orleans. And ignoring that reality is likely to make you feel you're being derelict. What's more, you may be concerned about appearances. Specifically, you may be worrying that a change of course will make your first decision appear to have been a mistake. And if your performance and career are judged mainly on the outcomes of decisions, it would be only human to worry about appearances. Nevertheless, get over it! Steeling yourself to focus on what's best for the future is good for the bottom line. Just ask John McCann, president of Athens, Ga.-based McCann Aerospace Machining Corp., a tier-one supplier to such firms as Boeing Co. and Lockheed Martin Corp. During the last decade, revenues at McCann Aerospace have increased 1,600% and the number of employees has quadrupled to 100. In addition, McCann's growth has occurred at a time when many of its competitors have been tightening their belts. McCann says a willingness to continually look ahead and invest for the future has been critical to his company's success. "If we didn't do that, we would either be out of the industry or out of the business," he says. And how does he avoid being sunk by sunk costs? By accepting the fact that changing market demands can make past decisions inappropriate for the present. "The marketplace dictates what you're going to do in the future," he stresses. "Your past investments may not necessarily be wrong, but the marketplace has changed," he says. Here are four other ways to avoid being pulled down by sunk costs:

  • Get a fresh perspective. When it's time to decide whether or not to continue with a project, seek input from people who weren't involved in the previous decisions, advises Ralph Keeney, professor at the University of Southern California, Los Angeles. Outsiders are less likely to have an emotional attachment, and should be less tempted to throw good money after bad.
  • Allow for failure. Don't create a culture in which failure is avoided at all costs. Keeney notes that when managers are judged only on the outcomes of their decisions, rather than on the processes used to arrive at them, they're going to do whatever it takes to make the outcome look good.
  • Reframe the issue. When revisiting a decision, don't waste time going over old issues or assigning blame. Instead, focus on new information and decide whether it supports a change in plan and action.
  • Consider zero-based budgeting. Evaluate projects from "ground zero" on a regular-typically annual-basis. An advantage: Zero-based budgeting decreases the temptation to continue funding a project simply because it's already on the books.

    Karen M. Kroll, president of Kroll Communications, Minnetonka, Minn., covers finance for IndustryWeek.

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