Sunk Costs and Organizational Decision Making - Research Paper Example

 Managerial Decision Making and Sunk Cost Abstract “Sunk cost” is a term borrowed from accounting and economics, referring to those costs that have been incurred and are therefore no longer relevant to future decision-making Thus, this research essay will animalize to what extent Do Sunk Costs Affect The Decision Of Firms In Different Industries to diversify into new businesses? 1) Introduction Sunk Costs refers to a cost that has been incurred in the past which cannot be amended by present decisions, and hence it cannot be refunded or recovered. For instance, if a company buys a government license for $ 100,000 for supply of lamp poles before it can manufacture such lamp poles and later the government makes a decision not to buy back the license or permit it to be resold. The $100,000 the company expends to buy the license is a sunk cost. Thus, sunk cost is one that when once it has been incurred, it could not be transformed or changed by a present decision. Thus, the company cannot rectify what was done by going back into the past and undo the decision made in the past. Further, it cannot be refunded or recovered as the government will neither permit the same to be resold or to will buy back the same. (Arnold, 2008, p184). Clark and Wrigley (1995) recognise three varieties of sunk costs which can efficiently produce a lesser or greater magnitude of such locational inaction. In the first type of sunk cost, for instance, for training costs of inward investors , whenever there is a requirement of significant skills to be harnessed , but on the assumption that lion’s share of such inward remittance based on low-skilled jobs and in such cases , sunk costs are particularly so significant. According to Peck (1996), the second type of sunk cost may be the cost of leasing or acquiring local property and land. Poignantly, a considerable quantum of such setup sunk costs may be met by subsidy from either central or state governments or shared by both by way of regional developments of grants and the leveling and provision of premises and sites. As per Gold (1981), there is a technical sense where the economies of scale is associated with the physical capacity which is notionally regarded as set-up sunk costs but none can be important in assessing industries and firms to specific places and the best illustration, here would be the location of chemical industries and petrochemical industries. Lastly, Clark and Wrigley recognise “exit” sunk costs, which become perceptible when a factory winds up its operations or a business exit from industry or a market. The best example here is the cost associated with pension provisions and severance pay. (Phelps, 2002, p 61-62). 2) Statement of the Problem- “Sunk cost” is a term borrowed from accounting and economics, referring to those costs that have been incurred and are therefore no longer relevant to future decision-making (Hirschey, 2009; Taylor, 2010). However, despite it irrelevance in terms of monetary reckoning, the psychological effect of “sunk cost” on the human decision making process remains evident. The effect of sunk costs on decision making in general has been a topic of interest in diverse areas such as human development (Kelly, 2004; Arkes, 1999) and education (Rover, et al., 2009). In business likewise, they figure unintentionally in managerial decision making. 3) Significance of the problem- Without realizing it, investors and managers are prone to the “sunk cost effect.” The disproportionate consideration of sunk costs constitutes a trap to decision making; positions are sometimes taken or products pushed too long in the hope that they may still turn profitable, because the investor or manager refuses to admit that it was a bad investment to the point of abandoning it (A to Z of Management Concepts & Models, 2005). In the interest of avoiding mistakes in decision making that will eventually affect firm profitability, studies should continue on the untoward effects of sunk costs upon decision making. 4) Literature Review Sunk costs are those costs which are spent in purchasing assets for the business like plant and machinery or expending on advertisement, which cannot be later reclaimed by either deploying the same for another usage or by disposing of that resource. Normally, these costs have been sustained in making an earlier decision and are not particular about a decision being presently made. For instance, a decision to enter into the airline industry will include buying new or second-hand flights, establishing ground support services and marketing and entering into new air routes. Suppose if the new venture turns to be unsuccessful, then the all the flights acquired earlier have to be disposed off and major portion of the initial investment may be recouped thereby making only a marginal value as sunk cost. However, most of the set-up costs are sunk in that they cannot be recouped or retrieved since they were earmarked for the particular project. Normally, higher the asset is to be used for a specific purpose, the greater the chances for the sunk costs. (Jones, 2004, p154). About 61 students at Ohio University were asked by Hal Arkes, a Psychologist of the university to presume that they had erroneously purchased tickets for both a $100 and $ 200 ski trip for the same weekend. Arkes asked them to assume that they could go on only one of the ski trips and would have to discard the unutilized ticket with them. Arkes also informed them to assume that they would in actual parlance have more fun on the $100 trip. However, the majority of the students said to have gone on the less enjoyable $200 trip. It is to be noted that sunk cost of the tickets should have been totally immaterial in this decision. Thus, than having more fun, high cost tickets have mattered more to the students. Further, irrespective of their selection of the trip, the total costs would have been $300, which is the cost of the two ski trip tickets in the aggregate. As this cost does not vary greatly between these alternatives, it should be disregarded. Like these students, most of the managers have a great deal of difficulty ignoring sunk costs when making their business decisions. (Gourville & Soman, 2002, p92-93). Sunk Costs can be incurred in many forms while the business decision making process. For instance, expenses on brand building, marketing , executing market research , obtaining legal permits during the initial stages of the business and these costs are unavoidable even in case of hiring of production facilities. Thus, the cost incurred for renting can be regarded as sunk costs as well. It is to be noted that there is no existence of market with no sunk cost or zero sunk costs. (Hirschhausen, Beckers and Mitusch, 2004, p24). As far as a new railway company is concerned, the sunk cost plays a significant role as the railway infrastructure as it is neither can be used alternatively or it can be disposed off in the secondary markets. Hence, market exit by a railway company will end in extraordinary costs. To analyse the importance of these sunk costs , it is necessary to learn whether the established railway company retorts to the market entry slowly or not. However, in the case of railways, the market entry will take a long phase of time, and the new entrant will have to incur huge losses in sales due to alternative network infrastructure, which symbolises a bottleneck. The choices for price setting for network owners and rail service providers are thus restricted. This is the cause for the major losses of the Deutsche Bundesbahn in Germany, which were due to various regulatory intrusions like the compulsory perpetuation of unprofitable rail connections, etc. (Hirschhausen, Beckers and Mitusch, 2004, p37). For instance, if a business owner or a manager is presently engaged in the process of modernizing their show-room and initially projected the cost for the same around $20,000. After the lapse one week, he finds that he has already spent around $8000 on the project and then realizes that his estimate was exceptionally low. Now, fresh estimate shows that to complete the project, another $10000 is needed. Having already spent $8000 , to complete the project , the owner needs to spend an additional $ 22,000 so as to not to lose the amount of $5000 spent initially. Though it appears to be easy, but it is unwarranted. Now, the owner has come to an understanding that he has lost already the initial chunk of capital, and it has become a sunken capital. No quantum of finagling or creativeness is going to bring reverse a true sunk cost. Internalizing the significance of sunk costs will assist the business manager to decide if the future benefits fall below the future costs –which has to be decided in the best interest of the business. For instance , sunk cost is also referred to the “ Concord Fallacy.” This denotes that how England and France prolonged to spend on the “Concorde” project on the basis that they had spent already huge sums on the project. Thus, it can be referred as wasting further dollars after wasting dollars earlier and also throwing good dollars after bad dollars. (Valentine 2010). A business manager may want to continue with a project even when he comes to know that project is failing in an increasing style which will be considered as an irrational economic decision, and it may include psychological motivations. Thus, the managers will experience some intricacies in failing to recognise the costs emanating from the past and to proceed to make investments in new resources. This is known as “Sunk Cost Effect.” Thus , the sunk cost effect can be seen, and it encourages economically illogical guises of demeanor. Thus, the business manager, who is the decision maker will turn to be a “slave” to the past decisions thereby enhancing the sunk cost and lands him in obscurity and due to this , he may find difficult to overcome this. In some scenarios , the proportion of form of articulating the investment appears to be more dynamically induce wrongful decisions. (Nevado 2003) Sunk costs will happen when there is a high level of switching costs or if a project has budget limitations. For instance, a software project team that has made huge investments on a new project will try to justify their decision when they come to be aware that the project is at stake. Further, some of the government’s giant, intricate IT projects prolongs to receive huge investment even after it came to light that the future of such a project was at bleak. Some business organisations will attempt to recoup huge investments in IT by placing band-aids on system issues or by bolting on functionality instead of redirecting the investments to better options. Some techniques to overcome the pitfalls of sunk costs: Ensure always that enough attention is focused on long-term goals and analyse how they would be served by the situation, if any. Try to analyse the status-quo substitute while considering the other options if it was just another choice rather than the fore-runner. Always keep away from inflated switching costs. Focus on available substitute choices in terms of present and future context. 5) Managerial implications (Khushalani 2007). 5. Proposed Research Question To what extent do sunk costs affect the decision of firms in different industries to diversify into new businesses? 6. A statement of limitations of the proposed research The proposed research shall not be able to gather operational performance statistics or specific sunk cost amounts attributable per project, and may have to rely on qualitative information or secondary data from earlier studies. Where possible, survey questionnaires may be administered or face-to-face interviews conducted, or both, as source of qualitative primary data. Review of literature method may be resorted. References Arnold, Roger A. (2008). Microeconomics. London: Cengage Learning. Gourville John & Soman Dilip. (September 2009). Pricing and the Psychology of Consumption. Harvard Business Review, pp 92-93. Hirschhausen Christian Von, Beckers Thorsten and Mitusch Kay. (2004). Trends in Infrastructure Regulation and Financing. International Experience and Case Studies from Germany. New York: Edward Elgar Publishing. Jones, Trefor. (2004). Business Economics and Managerial Decision Making. New York: Wiley and Sons. Khushalani Vishal. (2007,November 5). Decision Making Traps : The Sunk Costs Traps. Retrieved February 18 ,2011 from ://http://thinking.bigskyassociates.com/2007/11/decision-making-traps-part-3-sunk-cost.html Nevado , Pedro Picaluga. (2003). Persistence of Irrational Decision Making in Business Firms. Instituto Superior de Economia e Gestao – Department de Gestao Working Papers Series No 5 Retrieved February 18 ,2011 from ://http://www.repository.utl.pt/handle/10400.5/2257 Phelps .(2002). Multinationals and European Integration: Trade, Investment and Regional Policy Development. New York Routledge Taylor Francis Group. Valentine, Elizabeth. (2010,July 7). Understanding Business Decisions: Knowing the Meaning of Sunk Costs. Retrieved February 18 ,2011 from ://http://www.associatedcontent.com/article/5537830/what_does_sunk_costs_are_irrelevant.html?cat=3 Read More