An exploratory exercise to render a power view on sunk
cost in decision-making
JOSEPH KIM-KEUNG HO
Independent Trainer
Hong Kong,
China
Abstract: The topic of sunk cost has long been studied in the
accounting, psychological and economic fields. The topic has been examined from
a rather unitary perspective by endorsing a rational approach to make decisions
with a shared objective to gain maximum benefit to the whole system.
Psychological effect of sunk cost is recognized to exist but should be set aside
if rationality in decision making is to be maintained, unless it has
instrumental value to contribute to whole system improvement of some kind. This
paper challenges this conventional wisdom of sunk cost by putting forward a
power view on sunk cost. Such a power view acknowledges alternative images of
decision-making situation that are pluralist and coercive. To develop such a
power view on sunk cost, concepts from sunk cost, power and coercion are
reviewed. The resultant power view is portrayed in the form of a cognitive map.
The discussion developed on the power view is also inspired by contemporary
systems thinking, especially on the discussion of different ideal-types of
problem-situation from the critical systems thinking literature.
Key words: coercion, cognitive mapping, power, problem-situation types, rational
decision-making, sunk cost.
Introduction
The topic
of sunk cost has been studied in the psychology, economics and management
accounting fields. As a long-time
teacher and researcher on management accounting and contemporary systems
thinking, this writer finds it conceptually restrictive to confine its study based on the psychological and
economics standpoints. In particular,
the insensitivity to factors related to the theme of power, especially in
coercive situations, weakens the analytical power of the sunk cost notion. To
address this concern, this article makes an attempt to enrich the sunk cost
concept by offering a power view on it. This is done via an exploratory
intellectual endeavor, drawing explicitly on the literatures of three areas,
i.e., power, coercion and sunk cost. The
endeavor is also inspired by critical systems thinking, which is another
field of much intellectual interest to the writer. The study proceeds by, first
of all, introducing the basic ideas underlying the topic of sunk cost. It then
examines the nature and relevance of the topics of power and coercion to the
study of sunk cost. Subsequently, a
holistic view of power on sunk cost is proposed via a synthesis of ideas from
sunk cost, power and coercion. Such a
holistic view is rendered in the form of
cognitive map. The power dynamics of a coercive problem-situation that
involves decision-making with relevant-cost analysis and sunk cost is then
illustrated with a simple numerical example. Via this intellectual exercise,
the writer recognizes the relevance of white elephant projects as a major area
for the power view on sunk cost to apply as an analytical conceptual framework.
The basic ideas underlying the notion of sunk cost
In cost
and management accounting, sunk cost is covered in the topic of relevant-cost
analysis, being defined as "past costs that are unavoidable because
they cannot be changed no matter what
actions is taken" (Horngren, Datar and Rajan, 2015). One can conveniently
learn its basic idea in the context of rational decision-making by watching
some brief videos on it, e.g. Edspira (2014) and intromediateecon (2010). Sunk
cost can be classified into three types, namely, set-up sunk costs (i.e.,
irrecoverable initial investment costs), accumulated sunk costs (i.e. sunk
costs from normal working) and exit sunk cost (i.e., sunk cost arises from
abandoned projects) (Clark and
Wrigley, 1995). The
implication is that it should be ignored when making a choice in a rational
decision-making process (Horngren, Datar and Rajan, 2015: p. 448). In the words
of Essex (n.d), "It's a common business tenet that sunk costs should never
be considered a relevant factor in decision-making, Using sunk costs as a
factor in a decision is simply trying to justify past choices". For
Braverman and Blumenthal-Barby (2012), the intellectual rationale underlying
this line of reasoning on sunk cost treatment in decision-making is based on
classical models of rationality, notably, on normative standards of
rationality. These standards are "formal rules and principles that describe how people should behave
to achieve this optimization, and they are often used as a standard against
which individual behavior is compared" (Keys and Schwart, 2007). Nevertheless,
effect of sunk costs has been recognized and assessed from the accounting,
economic and psychosocial perspectives.
From the accounting perspective, sunk cost can be a relevant factor to
consider because "capitalized costs associated with a
project must be written off to expense as soon as the decision is made to
cancel the project. When the amount to be written off is quite large, this
encourages managers to keep projects running" (accountingtools.com, 2017).
Also, sunk costs can affect a company's pricing decision if it employs
"cost-based pricing" which could
include sunk cost in the cost calculation. This could happen when "marginal
cost is difficult to determine, as is often the case in real-life situations"
(Buchheit and Feltovich, 2011).
From
the economic perspective, sunk costs
are considered as "important elements of entry and exit decisions of
firms" in models of industrial dynamics (Hölzl,
2005). Specifically, "sunk costs increase the costs of entry and exit
symmetrically and create thereby a zone of inaction where entrants are less
likely to enter and incumbents less likely to exit" (Hölzl,
2005). The economic view of sunk costs is also explained in the YouTube video
of tutor2u (2016). In short, the economic view examines the economic impacts of
sunk cost, which does not directly challenge the soundness of relevant-cost
analysis and rational decision making as propounded in the accounting field.
From
the psychological perspective, (mis)perceived relevance of
sunk costs is encouraged by "loss avoidance", which is " the tendency to avoid choices that yield
sure negative payoffs in favor of alternatives that could yield positive
payoffs" (Buchheit and Feltovich, 2011). The misperceived relevance of
sunk costs in general is known as the sunk cost fallacy, which is more clearly
described as: "Reasoning that
further investment is warranted on the fact that the resources already invested
will be lost otherwise, not taking into consideration the overall losses
involved in the further investment" (logicallyfallacious.com, n.d.; Galef,
2013). In addition, it has been postulated that "sunk
investments set a mental account ‘‘in the red,’’ which causes people to
escalate their commitment to the current course of action in an attempt to
close the account ‘‘in the black.’’". (Cunha, Jr and Caldieraro, 2009).
From a rational decision-making standpoint, to the extent that these
psychological consequences from a chosen action can be foreseen, they should be
taken into account in the decision-making (Kelly, 2004). The psychology of
"Sunk Cost Effect" is tersely introduced in the YouTube video of
Torres (2014). Again, the psychological perspective explains the nature of the
sunk cost mindset but does not challenge the accounting view which endorses the
relevant-cost analysis way to deal with sunk cost in rational decision-making
process.
All
in all, the accounting, economic and psychological perspectives are related in
that they draw on ideas among them in their investigation on sunk cost. They
shed light on the influences and consequences of decision-making, involving
resource allocation, as well as recommendations on decision-making. These
perspectives do not rebut the twin ideas of the "conventional wisdom"
of sunk cost (Kelly, 2004), i.e., "individuals often do give weight to
sunk costs in their decision-making" [idea 1] and "it is irrational
for them to do so" [idea 2]. Idea 1 can very often be explained by
psychological and cognitive reasons. Idea 2 points to the consequence of
lowered decision-making effectiveness due to such irrationality. Admittedly,
the psychological view on sunk cost does tone down a bit the supremacy of the
rational decision-making approach underlying the relevant-cost analysis as
taught in management accounting. The accounting,
economic and psychological views of sunk costs can all be accommodated within a
rather unitary/ engineering lens on decision-making context. What is lacking, however, in the study of sunk
cost from these perspectives in decision-making, is the theoretical sensitivity
to the power, including coercion, aspects in the decision-making process and
decision-making contexts. The main intellectual
point to emphasize here is thus clear: the overall impression on the prevailing
literature review by this writer on sunk cost is that the accounting, economic
and psychological perspectives are primarily anchored on hard systems thinking,
see Jackson (2000: chapter 6) for a discussion on hard systems thinking. In
short, the conventional wisdom on sunk cost (Kelly, 2004) does not recognize
the existence of the political dimension of the decision-making context and the
divergence of interests/ goal incongruence among stakeholders in such context.
The two related topics of power and coercion are examined in the next section.
The nature and relevance of the power and
coercion topics to the sunk cost notion
The
notion of power has been defined in a number of ways. For instance, it has been
explained that "A has power
over B to the extent that he can get B to do something that B would not
otherwise do" (Dahl (1957) as cited by Lukes (1974).). In the same vein,
Pfiffner and Sherwood (1960) define it as "the capacity to secure the dominance of one’s
values or goals". Power has
also been perceived as embracing coercion, influence, authority, manipulation
and control of agenda of politics (Lukes, 1974). The academic literature on
power further distinguishes different types of power, e.g., expert, referent,
reward, coercive and legitimate (French and Raven, 1959) and relational power
(Chong, Fu and Shang, 2013) and functional power (Bell, Walker and Willer, 2015). Power exists in every position in an organization
(Kotter, 1985). A similar but broader view were made by classical sociological
theorists, e.g., Max and Weber that "power
relations were organized hierarchically and penetrated every level of modem
social organization" (Bell, Walker and Willer, 2015). Understandably, "(Shapiro et
al., 2011). In addition, Anderson & Berdahl (2002), among others,
argue that power makes people "less concerned about others' expectations
and more likely to express their true attitudes and emotions compared to the
powerless" (Hays and Goldstein, 2015). A particular type of power, namely,
coercion, needs some additional elaboration here due to its high relevance to
the line of thinking on sunk cost adopted by the writer in this article.
Frazier and Rody (1991) define coercive influence as
"the application of direct
pressure through communicating adverse consequences of non-compliance to
encourage specific behaviors" (Hausman and Johnston,
2010). Coercion restrains "the
freedom of choice or possibilities for action that compromises one's
autonomy" (Norvoll and Pedersen, 2016).
It has been argued that the power "to
coerce subordinates into taking specific actions is regarded as essential for
the efficient operation of hierarchically structured organizations" though
"individuals higher up in the hierarchy can abuse this power to their own
benefit and exploit subordinates" (Nikiforakis, Oechssler and Shah, 2014).
Coercion can be formal (e.g. regulated by law) and informal (e.g. reliance on
persuasion and leverage) (Elmer et al.,
in press). Lastly Chen (2017) points out that, in authoritarian regimes,
informal coercion, which uses on nonstate actors, such as vigilantes and thugs,
is often employed to maintain social order. Finally, Flood and Jackson (1991)
distinguish two types of coercive situations. In a simple-coercive situation,
genuine differences of interest, values and beliefs exist and "different
groups seek to use whatever power they have to impose their favoured strategy
upon others". The other situation type is complex-coercive, in which "true
sources of power of the various participants" are hidden (Flood and
Jackson, 1991). The topic of ideal-types of problem-situations (Flood and
Jackson, 1991), which is employed the discussion here, comes from the subject
of critical systems thinking (CST) (Jackson, 2000: Part III). And CST inspires
the writer to study sunk cost with a power view.
By taking note of some of the main ideas on
sunk cost, power and coercion, the writer is now ready to synthesize them to
render a power view on sunk cost. This literature synthesizing exercise,
performed with the cognitive mapping technique, is presented in the next
section.
Cognitive mapping a power view on sunk cost
To render a power view on sunk cost, the writer goes through two steps.
Step 1 is to group the academic ideas from the three topics of sunk cost, power
and coercion into a set of categories that are identified via a review of these
academic ideas. Step 2 is to link up the set of categories (as variables) to
make up a cognitive map (re: Facebook page on Literature on cognitive mapping).
The output of Step 1 is presented in the form of Table 1, as follows:
Table 1: Cognitive mapping variables and associated
academic ideas on sunk cost, power and coercion
Cognitive
mapping variables
|
Associated
academic ideas on sunk cost, power and coercion. (Quoted
statements come from the discussion in previous sections of this article).
|
1. Psychological
influence on stronger perceived sunk cost relevance
|
Point 1.1: "...(mis)perceived
relevance of sunk costs is encouraged by "loss avoidance", which is " the tendency to avoid choices that yield
sure negative payoffs in favor of alternatives that could yield positive
payoffs"...";
Point 1.2: "..."Reasoning that further
investment is warranted on the fact that the resources already invested will
be lost otherwise, not taking into consideration the overall losses involved
in the further investment"...";
Point 1.3: "..."sunk
investments set a mental account ‘‘in the red,’’ which causes people to
escalate their commitment to the current course of action in an attempt to
close the account ‘‘in the black.’’"....";
|
2. Misleading
influence of accounting practices
|
Point 2.1: "..."capitalized
costs associated with a project must be written off to expense as soon
as the decision is made to cancel the project. When the amount to be written
off is quite large, this encourages managers to keep projects running"..";
Point 2.2: "...sunk
costs can affect a company's pricing decision if it employs "cost-based
pricing" which could include sunk
cost in the cost calculation...";
|
3. The situation
(e.g., decision-making context) is coercive
|
Point 3.1: ".... power is an inevitable facet of
organizational life when "resources are limited, interests are divergent, and interdependence is
high"...";
Point 3.2: "...in authoritarian regimes, informal
coercion, which uses on nonstate actors, such as vigilantes and thugs, is
often employed to maintain social order";
Point 3.3: "In a
simple-coercive situation, genuine differences of interest, values and
beliefs exist and "different groups seek to use whatever power they have
to impose their favoured strategy upon others". The other situation type
is complex-coercive, in which "true sources of power of the various
participants" are hidden";
|
4. Exercise
of power, including coercion
|
Point 4.1: "... "A has power over B to the extent
that he can get B to do something that B would not otherwise do"..";
Point
4.2: "...coercive influence as "the application of direct pressure through communicating adverse
consequences of non-compliance to encourage specific behaviors"...";
Point 4.3: "...power
makes people "less concerned about others' expectations and more likely
to express their true attitudes and emotions compared to the powerless"...";
|
5. Sunk
costs viewed as irrelevant
|
Point 5.1: "...sunk cost is covered
in the topic of relevant-cost analysis, being defined as "past costs
that are unavoidable....";
|
6. Increase
in of industry entry and exit barriers
|
Point 6.1: "..."sunk
costs increase the costs of entry and exit symmetrically and create thereby a
zone of inaction where entrants are less likely to enter and incumbents less
likely to exit"...";
|
7. Rational
decision-making
|
Point 7.1: "... classical models of
rationality, notably, on normative standards of rationality";
|
8. Improved
business profitability
|
The 8 variables are recognized via a kind of open coding exercise[1]
on the literature review findings on the topics of sunk cost, power and coercion.
With Table 1, showing 8 variables on the topics of sunk cost, power and
coercion and associated points noted from the writer's literature review, the
writer can now link up these variables in a plausible way to produce an integrated
power view of sunk cost in the form of a cognitive map (Step 2) in Figure 1 as
follows:
The power view on sunk cost, as portrayed by Figure 1, renders an
intellectually informed conceptual framework on sunk cost that is aware of the
power factor in decision-making that involves the sunk cost issue. It shows why
and how the power factor can influence the sunk cost topic in decision-making,
e.g., on resource allocation and investment projects and exposes the key driver,
i.e., "A coercive situation (variable 3)", that encourages irrationality
in decision-making as understood with unitary/engineering lens. Specifically, it
clarifies conceptually why and how white elephant projects[2],
being significantly affected by various coercive/ power factors (see Ho (2016),
inevitably trigger complaints and arguments over sunk cost concerns.
The following example provided as Table 1 on a relevant cost analysis
illustrates a scenario on how sunk cost
can take place and has been handled in a project evaluation.
Table 1: A relevant
cost analysis on a project with sunk cost
Time 0
|
Time 1
|
|
(dollars in thousands)
|
(dollars in thousands)
|
|
Relevant
revenue
|
$ 10,000
|
10,000
|
Relevant
cost
|
||
1. Discussable
|
$ 4,000
|
4,000
|
2. Undiscussable
|
$ 9,000
|
|
Additional
profit/ loss
|
-$ 3,000
|
6,000
|
Sunk cost
|
-
|
9,000
|
Referring to Table 1, at Time 0, a group of decision-makers are conducting
a relevant-cost analysis on an investment project. The time bucket of Times 0
and 1 can be 1 months, but more likely to be longer, e.g., 9 months to 1 years.
Since some of the decision-makers have much more relational and position power
as well as personal benefits if the project is introduced, they exert formal
and informal coercive influence on the decision-making process. Because of
that, the decision-making process is not transparent. For example, certain
relevant cost items become undiscussable and queries on them are ignored. There
is an estimate of their cost at $9 million. It is very likely that the figure
of relevant revenue at $10 million of the project is a highly inflated figure. However,
the estimated relevant revenue and cost are not able to be verified, due partly
to nondisclosure of vital information on these revenue and cost items. As a
result, a decision is forced through at Time 0 based on the reasoning that the relevant
revenue of $10 million is larger than the discussable relevant cost of $4 millions.
The conclusion from such an analysis at Time 0 is that the project is expected
to create a net gain of $6 million. However, there is a vehement objection from
the less powerful members of the decision-making group that the project might
be generating a net loss of $3 million, if the undiscussable amount of $9 million
is to be included in the analysis. As the project progresses to Time 1, a
second relevant-cost analysis is carried out by the group of decision-makers.
It is estimated that the project will generate a relevant revenue of $10 million
and incurs a relevant cost of $4 million. However, $9 million has already been
spent on the previously undiscussable cost items at the end of Time 0. This
amount of expenditure of $9 million is now argued by the powerful members of
the decision-makers to be a sunk cost. They now argue that it is irrational for
the less powerful members of the decision-making group to keep referring to
this sunk cost in the relevant-cost analysis at Time 1 and complaining that the
project is exceedingly expensive. At the same time, the powerful members also
remind the less powerful (coerced)
members that they should be committed to the project because so much money
(i.e. the sunk cost) has already been spent on the project. Thus, from the
standpoint of the powerful members of the decision-making group, the relevant cost
analysis at Time 1 is now a comparison of the relevant revenue of $10 million with
the relevant cost of $4 million, resulting in a net gain of $6 million. Meanwhile,
the sunk cost now offers a psychological incentive to support the project. One
thing that stands out as a prominent project feature is that the project has a
quite substantial amount of sunk cost (i.e., the $9 million), very often also
labeled as an outsized unexpected cost overrun item. A project with such a
substantial amount of sunk cost is typical of white elephant projects (Ho,
2016). The relevant-cost analysis does
not detect the coercive influences at work in a coercive decision-making
context, since it is grounded, uncritically and tacitly, on a unitary view of
decision-making situation wherein the objective of profit maximization for the
whole system is assumed to be clear and endorsed by all the members of the
decision making group, As a result, the relevant-cost analysis is rational; regrettably
in this case, it also primarily guides decision-makers to conduct a
"correct" analysis to serve a coercive social system. The
relevant-cost analysis is, at certain phases of the investment project life
cycle, partial, thus misleading and irrational, due to coercive influences,
which can be formal or informal, made by certain members of the decision-making
groups. With the coercive influence, sunk cost is both ignored because project
is now profitable (e.g., making a profit of $6 million at Time 1) and heeded for it
now lends emotional endorsement to the project. These members exercise coercive
influence in order to serve their own interests at the costs of other people,
or even the society at large. They have no problem to utilize the relevant-cost
analysis and the sunk cost idea to strengthen their line of argument in support
of their favoured project. The underlying dynamics of coercive influences in
this example is summarized in Table 2 to improve its comprehensibility.
Table 2: The
underlying power dynamics of relevant-cost analysis involving sunk cost
Time 0
|
Time 1
|
|
1. Tactics
of coercive influence exercises
|
* Make some of the sizable project cost items undiscussable so that
the favoured project can be accepted by a relevant-cost analysis without the
inclusion of the undiscussable cost items.
* Make the assumptions underlying the highly inflated revenue figure undiscussable.
*Make the assumptions and nature of a number of vaguely expressed
qualitative project benefits, costs and risks undiscussable, even though they
are not included in a relevant-cost analysis on the project anyway.
|
* Ignore the cost spent on the undiscussable cost items (at Time 0) as
irrelevant for a proper relevant-cost analysis.
* Recognize the sunk cost as offering a valid psychological
consideration to commit to the project.
|
2. Ostensible
project goals
|
* Partly to achieve maximum economic gain for the whole system.
* Partly to achieve several vaguely defined non-financial goals.
|
* Partly to achieve maximum economic gain for the whole system.
* Partly to achieve several vaguely defined non-financial goals..
* Gain psychological comfort from the sunk cost mentality by endorsing
the project.
|
3. Genuine
and hidden goal
|
* Primarily to obtain hidden personal gain for certain powerful
stakeholder group at the expense of the whole system.
|
* Primarily to obtain hidden personal gain for certain powerful
stakeholder group at the expense of the whole system.
|
4. Problem-situation
types
|
* Simple-coercive to complex-coercive.
|
* Simple-coercive to complex-coercive.
|
5. Existence
of sunk costs
|
No
|
Yes
|
Overall, the power view on sunk cost (re: Figure 1) in decision-making,
including its underlying dynamics (re: Tables 1 and 2) constitutes an idealized
reference framework to examine discourses on relevant-cost analysis and sunk
cost effect in a coercive problem-situation. While the unitary perspective has little
difficulties to accommodate the accounting, economic and psychological views of
sunk cost, it is quite incapable to adopt the power view for decision-making. The
only way to employ such cost and relevant-cost analysis in a coercive situation
is to use these concepts in a language game with the ultimate aim of for serving
self-interest of the power stakeholder group in such a situation. Because of it,
this power view is highly relevant for enriching analysis of decision-making
case study that involves sunk cost, notably on white elephant projects (Ho,
2016).
Concluding remarks
There is no denying that the rational decision making process, on which
the notion of relevant-cost analysis and the ingredient sunk cost concept are
based, is a powerful analytical approach to guide decision-making making. It is
also true that substantial research efforts and findings have been produced on
sunk cost study from the accounting, economic and psychological fields. Nevertheless,
the existing academic literature on it endorses a rational decision-making
approach and does not at the end of the day challenges its superiority for
guiding decision-making. As such, its underlying orientation is chiefly
associated to hard systems thinking and the unitary perspective in systems
thinking terms. It is now time enrich the study of sunk cost by examining it
from another perspective, namely, the power and coercion one, so that a key blindspot
of the mainstream perspectives on sunk cost study is recognized and dealt with.
Doing so in sunk cost study promotes a multi-perspective to examine sunk cost
and decision-making in the broad field of social sciences, including various
management disciplines. They include management accounting, project management
and organizational decision-making, among others. Surprisingly, sunk cost has
not been investigated in this multi-perspective in the academic community so
far. This makes the study here quite novel in the academic field. It should
encourage more research on sunk cost study in this and other original
perspectives. Nevertheless, conducting research with the power view is
challenging because the decision-making process in coercive situation is filled
with exercises of formal and informal coercive influences as well as very low
information transparency.
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[2] A white elephant project is "‚….An unprofitable investment
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to actually make a profit.‛ (Investopedia.com, 2016).
