Thursday, January 22, 2015

The Art of Decision Making - Sunk Costs

One of the life changing concepts I have recently learned during my MBA studies is to when effectively walk away from a business. Let's face it, we have more or less been all living in a society which dictated the myth that as long as we have previously invested substantial energy, time and money into something, we should continue doing it, even if the future benefit might get negative or we just hope to bring in some profit.

After studying about the concepts of relevant costs I do not agree with this traditional reasoning - past costs, known as sunk costs, should be never accounted in future decision making. You should just look at the present...the t = 0, when considering costs... Look at it this way - wondering about the future? Then consider only the FUTURE costs and the FUTURE benefits. The future benefit should always be more than the future cost if you decide to give green signal to a project.

For most people, including business men, they find it difficult to detach themselves from something which costed them lots of money and energy to get that far and they aren't seeing the profit yet. This is wrong.

Now quick question for my blog readers to ponder about: How many times did your manager, CEO or CFO, base his financial decisions on irrelevant sunk costs? And what can you tell about the outcome of such decision?