Governance, Leadership and Sunk Costs

Scene: Board Meeting

Director 1: Thanks for providing these numbers. I see we continue to lose money on the prevention program – what can we do about it?

Director 2: The problem is nobody knows about this program. I was speaking with a local last week who had never heard of it! Are we doing anything to get the word out?

Staff member: Two years ago we paid for a marketing consultant. Last year we hired an assistant for Stan to free him up to get out in the community and promote it. Just last month we bought Google ad words for $5500.

Director 2: Great – how are the results?

Executive Director: Client numbers are down and the program’s deficit keeps climbing – although less steeply than last year. We were discussing this in the management team and we think there are a couple of key donors who would really get behind strengthening the program with both a city-wide billboard campaign and an additional full time counselor to finally enable us to offer wrap around services. So we’d like to propose…

New Director (interrupting): You mean this program has had continually increasing investments over the last three years, continually declining client numbers, increasing deficits and you want to add 50% more to the funding and hit on two major donors to support this?! I’d much rather propose we eliminate it and focus these resources somewhere more productive.

Chorus: Are you crazy?! We have invested in the high six figures in this program – we can’t let that investment go to waste! (This is the attachment theory of management and governance – i.e. emotionally attached to past investments)

Haven’t you been through a milder version (hopefully) of this in a staff meeting, board meeting and in your own mind? Don’t be too sure your organization isn’t falling prey. We get very attached to what we have invested in (think marriage and kids). A sunk cost is an unrecoverable cost for which you are already liable. Sunk costs have been or will be paid regardless of the decision whether or not to proceed with the project. Therefore they are irrelevant to the current decision and should not be included in the analysis (tell this to the emotions and values you have invested heavily in a project over some years).

Here is a famous example from Robert H. Frank which shows how the sunk cost fallacy can sneak up on you.

Cornell University has two sets of faculty tennis courts, one outdoor and the other indoor. Membership in the outdoor facility is available for a fixed fee per season. There is no additional charge based on actual court use. The indoor facility, by contrast, has not only a seasonal fee, but also a $12 per hour charge for court time. The higher charges of the indoor facility reflect the additional costs of heat, electricity and building maintenance. The indoor facility opens in early October, a time when the Ithaca weather can be anything from bright sunshine and mild temperatures to blowing sleet and snow. The outdoor courts remain open, weather permitting, until early November. During good weather, almost everyone prefers to play on the outdoor courts, which are nestled in one of Ithaca’s scenic gorges.
Demand on the indoor facility is intense, and people who want to play regularly must commit themselves to buy a specific hour each week. Having done so, they must pay for the hour whether they use it or not. Here is the problem: You are committed to an indoor court at 3:00PM on Saturday, October 20 (you have paid for it-sunk cost), the only hour you are free to play that day. It is a warm, sunny autumn afternoon. Where should you play, indoors or out?

You’ve probably guessed by now that you should enjoy the outdoor court with a clean conscience. Here are two common examples of sunk costs:

Fixed overhead expenses. Overhead expenses are associated with activities that are not directly attributable to a single business activity but instead affect many different areas of the organization. They are often allocated to the different business activities for accounting purposes, for cost analysis or for reporting to grant makers. To the extent that these overhead costs are fixed and will be incurred in any case, they are not incremental to the decision and should not be included in analysis.

Past R&D expenditures. When you have already devoted significant resources to develop a new program, there will be a tendency to continue investing even if market conditions have changed or otherwise demonstrated it is unlikely to be viable. That rationale that is sometimes given is that if the program is abandoned the money that has already been invested will be “wasted.” In other cases, a decision is made to abandon the project because it cannot possibly recoup the investment that has already been made in it. Neither argument is correct: Any money that has already been spent is a sunk cost and therefore irrelevant to the future.