An exploratory exercise to render a power view on sunk cost in decision-making

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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[1] In grounded theory method, open coding is an analytic process aiming at "developing substantial codes describing, naming or classifying the phenomenon under consideration" (Wikipedia, n.d.).

[2] A white elephant project is "‚….An unprofitable investment ….that is so expensive to operate and maintain that it is extremely difficult to actually make a profit.‛ (Investopedia.com, 2016).