You watch your friend spend a day trying to fix the air-conditioning system on his car, only to realize that he has made literally no progress in figuring out how the system works. You meet him in the evening and recommend he go to a reliable auto-repair shop. He says: “But I just spent the entire day working on this. I am not about to waste that time. I plan to continue working on it tomorrow.” You walk away thinking, “The fact that he has not made any progress all day should be telling him that he is out of his depth.” Amazingly, as several studies in decision research have discovered, this is frighteningly close to how many important decisions are made in the business world.
Too often, executives justify further investment in an initiative on the basis of what has already been invested in it. Let’s say your company launches a product. After one year of labour and an investment of at least Rs1 crore, the product sales fail to pick up. The management team can continue to throw good money after bad, arguing that we can’t just walk away from a Rs1 crore investment. If things still don’t turn around, a Rs1 crore loss could balloon into a Rs2 crore loss or more.
Generally, we would consider managers to have conviction in their plans, and to not be deterred by setbacks. While that would seem to be the right thing to do, they must take some precautions when evaluating projects that have not yet met the success criteria. There is a real danger of falling into what has been referred to as the “escalation of commitment” trap. Why does this happen? There are several potential causes. First, changing a course of action involves an implicit admission that the path you were on wasn’t the right one. Admitting to a mistake is difficult for most of us. Second, we view the additional investment in relation to what has already been invested. For example, after having invested Rs1 crore in the first year, the management team may now be faced with a decision of investing an additional Rs20 lakh. It seems like a reasonable gamble to invest this to recover the entire Rs1.2 crore from the project. Psychologically, we believe we have crossed the point of no return, and the new investment seems to be an extension of the earlier decision that started us down the current path. Finally, in most business decisions, unknown factors can influence the outcome. So, it becomes easier to believe that the poor outcome was based on factors that wouldn’t be repeated and that things would get better with additional investment.
So, how should one approach decision-making to avoid this trap? From an economic perspective, it makes sense to treat the investments already made as sunk costs. These are the costs that have already been incurred (and, for all practical purposes, should be treated as unrecoverable) and should not be factored into the next decision. The next decision has to be based purely on the merits of the situation as it stands today, and not in relation to the baggage that it brings with it. In fact, the poor outcome with the prior investment should be considered additional evidence that the future investment may not be worthwhile. Ask yourself this: Would someone who has not been a part of the project so far be willing to put down Rs20 lakh to take over the project?
It is worth noting that the escalation of commitment effect can actually be used in a positive way too. Let’s say you are trying to lose a few pounds and have joined a gym. You promise yourself you will go to the gym every day for the next two months. It is day 45 and you just don’t feel like going. You can use the escalation of commitment trap to work in your favour by recalling all the days you have already invested. Tell yourself that missing one day may actually set you back several weeks. Is it worth losing the benefits of all your effort just for one day? Once you see going to the gym on a particular day in reference to all the days that you have already invested, it will be easier to get off that couch.
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Praveen Aggarwal and Rajiv Vaidyanathan are professors of marketing at the Labovitz School of Business & Economics at the University of Minnesota Duluth. Aggarwal also serves as head of the marketing department and Vaidyanathan is director of MBA programmes at the University of Minnesota Duluth.