Sunk Costs in Projects and Relationships…
(by Gerard van Lier, PMP)
Sunk costs are costs that have already incurred and cannot be undone. In making economic and personal decisions, one should not take sunk costs into account. However, including the sunk costs when deciding whether a project should be stopped or continued is a known pitfall. Why is it that we often tend to let our decision be influenced by the amount of the investment that has already been done?
One important reason is that, despite the fact that sunk costs should not be taken into account, these costs may have impact on the future returns. In the current project, significant development and production costs have been made already, such as the acquisition of knowledge and the delivery of designs. These costs must often be remade for a new project. A company that has already invested a lot of money in a project will therefore be less likely want to stop the project. But when there are only limited investment opportunities it is harder to invest in a new project while the old project is running too. What the company should do is determine what additional investment in the old project will bring and compare that with what the investment in the new project brings as a net result. It does not matter what the investment was in the past. It matters what further investment brings.
An example: we invest 100,000 euros once in a project of one year to obtain for 3 years thereafter a return of 50,000 per year. The net result is in that case 3 x 50.000 – 100.000 = 50,000 euro. But when the project costs, after having invested 100,000, would have to be raised due to setbacks and to secure the results with an additional 50,000 to 150,000 euros, the net result would drop to 3 x 50.000 – 150.000 = 0.
So stop that project!… many people would say. We have already invested so much, quitting is not an option!… others would say.
The fact is that much has been invested. It is also a fact that there is a loss of 100,000 euro when the project would be stopped immediately. On the other hand, by investing another 50.000, the loss can be reduced to 0.
The sunk costs of 100,000 are behind us and there’s nothing we can do about it. What we know is that by investing another 50,000, we can achieve a result of 100,000. We can therefore compensate our loss. The assumption is of course that it is likely that it will really happen this time. We therefore need a good business case that shows that this is going to work now. Not only the numbers but also an assessment of the risks and an explanation why it did not work the first time, are required.
It seems like the sunk costs should not be taken into account. However, when deciding on future investments we yet do that often, and it is also good that we do that. It just should not happen because we have invested so much. It should happen because we may need only a little additional investment for maximum result.
Note that it usually also requires additional costs to stop a project. These costs may be penalties of existing purchase orders or legal fees. But also damage to reputation and morale of employees can be costly. These costs must also be included in the trade-off between continuation and stopping, not only the remaining costs and returns.
Also one must consider whether it is likely that the estimate of cost and time will be correct for the next project part, while the last time or times it was not. The final project outcome may still be a loss while rationally, it is sensible to continue. This means that the business case must continuously be calibrated while the project manager and/or project owner are still accountable for the ultimate (negative) result. In other words, they should not get away with a ‘new’ business case that always paints a rosy picture of the future!
So far the sunk costs. For now it is important that we know whether we still believe that it stays with that 50,000 euro… And what we would do with those 50,000 euro, would we stop the project anyway. It may be possible to obtain a result of 200,000 euro if we invest the 50,000 euro in an alternative project. Let’s assume that by investing that 50,000 in the current project we cannot do the alternative project. In that case, the result that we could achieve in the alternative project is definitely lost and these results need to be considered as additional costs. This is called opportunity costs.
The sunk costs are indeed not important. We need to look at what additional investment brings us. We only need to consider the opportunity costs in that dialogue, and that is sometimes forgotten. Also, we often want to compensate our loss, something that happens to many gamblers…
So the inclusion of sunk costs in the decision to stop or continue is not a good idea. It is also not a good idea to simply think that an additional investment is much more likely to succeed than the investment that has already been done (in gambling it is likely that the additional investment disappears as quickly as the first part).
And we need to look at alternatives because the amount of investment may be more beneficial to an alternative project than investment in the existing project. The sunk costs do not count, but the opportunity costs do count! And it is likely that we know with greater certainty what the remaining costs are for an ongoing project than for a project that just starts.
Unconsciously we do this the same way in maintaining relationships. We invest in the relationship and want something in return. If that fails, we look back. We may think that already a lot has been invested, and that it therefore does not seem useful to stop and write off that investment. Because we already have invested much we are confident that we will obtain a result for this investment. That is quite possible, as it is possible in our project of 100,000 euro that will now cost 150,000 to prevent a loss of 100,000.
But here too, the investment should simply be regarded as sunk costs. The extra investment not necessarily has to lead to the desired results. We should therefore, like we do for projects, make a business case that shows what the risks are and that explains why it was unsuccessful and why it is going to work the next time. This is not a business case with numbers but an emotional business case with which we can rationally decide to invest more or not.
When it is likely that an alternative relationship brings a significantly better result, it may be wise to stop or reduce investing in the current relationship. Don’t look at the sunk costs but look at the opportunity costs. Just as this is applicable for projects.
I wish you good decisions!
Gerard van Lier, PMP is managing partner with The PMO Company since 2009. He started his career in product development of glass-fiber technology in an international telecommunications company after which he is active in project management for telecommunications and information technology after 1994. He is a specialist in corporate program and portfolio management. A broad and international experience and the extended knowledge of project management and portfolio management techniques enabled various successful implementations of organization- and project governance in multicultural environments.