It’s Eddie time, y’all.
Last week, I described and we explored the notion of sunk cost fallacy. There have been many business articles written about sunk cost fallacy, yet many propose no solutions other than to be aware of it. In this week’s article, I will propose some ideas to overcome sunk cost fallacy.
The best way to reduce the effects of sunk cost fallacy is to evade it altogether and not find yourself in a position where one has to contemplate it.
One method is through modularization. This idea is from my business mentor, who is an executive at a prominent and successful oil & gas producer in Calgary. While we did not discuss sunk cost fallacy directly, he described how his company develops projects vice one of his competitors. There’s no escaping numbers, but I’ll try to keep it simple. Bear with me and follow my logic.
The decision revolves around how to develop an oil property. It can either be done building one large plant at one time or by building it in phases that produce oil individually.
Table 1: Economics of an Oil Property
|ABC Corp||XYZ Corp|
|Project Benefits||$10 billion||$10 billion|
|Strategy||Build 1 large plant||Build a modular plant in phases|
|Project cost||$7 billion||5 plants @ $1.5 billion each = $7.5 billion|
|Duration||3.5 years||1 year per phase|
|Net Present Value||$3 billion||$2.5 billion|
Based on this information alone, the ABC strategy is better. It results in a higher NPV and takes less time. The cost of developing the plant and extracting the oil are lower. Given the equal benefit to both projects, ABC Corp’s project is better. Simple right?
However, the risk to ABC Corp’s strategy is much higher and is more susceptible to a manager faced with a sunk cost fallacy decision. This is because it takes the entire project cost to realize one dollar in revenue. If the project spends $6.9 billion and stops, there is no possibility of seeing revenue. If the economic fundamentals of the project change midway through the project (say a drop in oil prices), the company is forced into a situation with implications of sunk cost fallacy. Should the project continue despite it being ridiculously unprofitable? Or do we cut our losses at $3.5 billion?
Management at XYZ Corp will not face such a daunting decision. By building the plant in phases, albeit at higher costs, they give themselves the option to make more logical stops along the way. If the economic fundamentals of the project take a turn for the worse, their maximum loss is less than $1.5 billion. Or, despite the fundamentals being worse, the current phase of the project may still be worthwhile to develop given the relatively small amount of money needed to finish the next phase. Although XYZ Corp will pay a higher cost to develop the project, they give themselves ‘outs’ over the duration of the project that allow them to better react to the changing economy and gives them more flexibility than ABC Corp. Furthermore, modularization does not trap XYZ Corp into a situation where sunk cost fallacy can flourish.
Modularization is an effective way to avoid situations that present decisions where the magnitude of sunk cost fallacies can be high. By investing small amounts based on market conditions and providing flexibility in decision-making, sunk cost fallacy can be avoided.
Note: the example outlined above is for demonstration purposes only and contains many inconsistencies from a finance perspective. It is meant to illustrate the purposes of sunk cost fallacies and is not entirely accurate of the true costs and benefits of both strategies (for example, the revenue that each phase would produce as each is completed). Take it in the spirit in which it was intended.