Sunk Cost Bias, Example & Decision-Making in Business
We think we are rational decision makers, but our decisions are predominantly controlled by the automatic, intuitive mind(Emotional mind) rather than the rational mind.
Decision-making is an inherently complex process that involves a significant amount of cognitive effort. If a rational mind has to get involved in making a decision, it would consume a lot of energy in performing those cognitive tasks because of the ‘working memory’ limitations. This would impart a feeling of fatigue. In other words, our ‘mind system’ is naturally against rational decisions.
To counter this fatigue, the human mind has evolved over aeons to automate a lot of behaviours and use a lot of mental shortcuts as much as possible, in responding to various scenarios. These mental shortcuts are called ‘Heuristics’ which our automatic, intuitive mind use to influence our decisions.
Sometimes, these heuristics help us but many times it would prove fatal. It had resulted in bad decisions and was particularly responsible for many business failures.
Some of the driving elements behind those mental ‘heuristics’ in our intuitive mind are our own hidden beliefs & prejudices(Cognitive Biases), which are shaped by past experiences and the environment in which a person grew up. What makes all these ‘heuristics’ so dangerous is their invisibility to the decision-maker. We fail to see or recognize them.
“Sometimes the fault lies not in the decision-making process but rather in the mind of decision maker” -John S. Hammond
Sunk Cost Bias is one of the heuristics that influence decision-making and has the potential to wreck the businesses.
THE SUNK COST
Once, I and my wife have booked tickets for a new Malayalam movie. A couple of hours before the movie time, we went through the movie reviews and it was really bad and scary.
Me: “Looks like it would be tough to sit and watch the movie for three hours”
Wife: “Let’s skip this movie”
Me with an irritated voice: “No. We have paid Rs.500 for the tickets. It would go waste. Let’s Go”.
She immediately looked at me and smiled, “Sunk cost at work and.. you… taught me from those books” and she pointed out at a couple of books in my book rack.
It is true that we cannot recover the money whether we go and watch the movie or not and it should not have played a role in our decision-making but unknowingly it influenced my mind leading to inappropriate decisions.
Definition -The Sunk Cost is a mental shortcut that would force an individual to continue investing his or her time, money, emotion in a losing activity because of their earlier investments.
John S Hammond writes “Sunk cost is a kind of a trap which will force a person to make choices in a way that justifies past choices”.
Example -Investors often refuse to sell their stocks at a loss as they had already invested so much money and time with that stock. The investor should have made decisions based on the future value of the stock or the alternative investments rather than the value of past investments which are anyway irrecoverable.
Loss Aversion -One of the reasons why people fall into the trap of ‘Sunk Cost’ bias is the ‘Loss Aversion’ phenomenon. By nature, we focus on what we may lose than what we may gain. In the movie tickets scenario, I was unknowingly focussed on losing the money I spent on the tickets rather than thinking about what I would gain. Our aversion to loss is a strong emotion.
Afraid Of Admitting Mistakes -Another reason why a person would fall into ‘Sunk Cost’ trap is the unwillingness to admit that he or she made a mistake, particularly in a business environment.
John S Hammond provides an example - If you fire a poor performer(even after investing an enormous amount of effort) whom you hired, you are publicly admitting of your poor judgement. You would naturally let him or her to stay on, even though the choice compounds the error.
As decisions are made by people, biases like ‘Sunk Cost’ have sunk many businesses but some companies have successfully overcome those challenges. Let’s see about one such successful company by name ‘Intel’.
Let’s see how Intel overcome Sunk Cost Bias while transitioning from memory business to microprocessor business.
INTEL‘S EXIT FROM MEMORY TO MICROPROCESSORS
In the early 1970s, Intel was nearly a monopoly in manufacturing and supplying memory chips(DRAMs). The company ruled the market and memories had become Intel’s identity.
In the late 1970s, Japanese memory producers entered the PC market to fill the product shortages as Intel struggled to meet the demands. Slowly their share of the market began to rise. Before Intel realised the problem, the Japanese had become a major competitor and turned the DRAMs into a commodity product. Intel began to lose money rapidly.
It was frustrating for Intel’s senior management team and the employees. They didn’t know how to react. Intel’s CEO Andy Grove and Chairman Gordon Moore pondered various solutions to stem the loss as well as the future course of action.
In the meantime, One of Intel’s team developed a microprocessor and it was gaining a foothold in the PC market. Being new, the microprocessors’ growth was slow at that time.
Should Intel invest more in protecting the memory business and fight Japanese manufacturers or should the company flee from memories market and create a new growth market? It was a business growth dilemma.
The time was just running out but Andy and his team struggled to arrive at a solution. The indecision lasted more than a couple of years.
One of the reasons why Intel took so long to decide was ‘Sunk Cost’ Bias.
How did Intel overcome those challenges?
SUNK COST BIAS IN DECISION-MAKING
Intel was founded and built on memories. The people of Intel grew along with the company. Memory Chips had become their identity. They had invested a lot of their time, mental energy, emotion and money in learning, training and developing skills related to memories. People in the manufacturing and production sector had developed and refined their technologies on memory products.
Their personal identity had become inseparable from the professional life. They did not want to leave the ‘memory chips’ identity they had built over the years. They did not want to forego the investments, learnings and knowledge. So they resisted any change from memory business.
Past Emotional Investments Wreck Havoc -Unconsciously, Intel’s management team including Andy Grove was also looking for a solution that would justify their old investments like machines, processes, infrastructure, technology, employee training and their past choices.
The more you invest in something the harder it becomes to abandon it.
The sunk cost bias preyed on the minds of Andrew Grove and other executives. To save the investments, they were adding additional funds to build infrastructure, buy special purpose machinery, provide additional training to employees to improve the quality of memory chips. A classic case of making choices to justify past choices, unconsciously protecting their earlier flawed decisions.
Once the situation got worse, it became difficult to publicly accept that their earlier judgements were wrong. The Intel team continued to invest funds with the hope that business would recover rather than admitting the mistake. For some time, Intel was throwing good money after money that had gone bad -A classic case of ‘Sunk Cost’ bias in action.
OVERCOMING SUNK COST BIAS
How did they overcome Sunk Cost Bias?
Think From An Outsider’s Perspective -One of the ways Andy Grove and Gordon Moore solved the problem of Sunk Cost bias was to think from an outsider’s perspective.
One day in 1985, Gordon Moore and Andy Grove were restless as the losses were mounting badly and their indecision was affecting the morale of employees.
Andy asked Moore, “If we got kicked out of this company and the board brought in a new CEO, what do you think he would do?”
Gordon immediately replied, “He would get us out of memories”.
Andy with a surprised look, “Why shouldn’t you and I walk out the door, come back and do it ourselves?”
Thus, Andy and Gordon took a decision that changed the identity of Intel.
Outsider Has No Past Investments -In any company, new CEOs recruited from outside sources or new department heads transferred from other departments hold one advantage -They do not have an emotional stake or emotional attachment in the earlier decisions -They are capable of applying an impersonal logic to the situation unlike the person who devoted entire lives to the company or department and therefore has a history of deep involvement in the earlier decisions.
Andy and Gordon went on to interchange people and department heads, reassigned the roles, responsibilities and duties and put entirely new people in charge of some departments. This helped in avoiding the sunk cost bias to an extent as the new people were uninvolved and non-committed to the earlier decisions within the department. They had no problem in pointing out the earlier mistakes within the departments.
One of the ways to escape Sunk Cost Bias is to understand that other people will not see the problem from the same perspective as we do. Once you knew it, you need to seek out different perspectives of the problem. This would help you to reframe the problem.
Andy Grove met many of his employees from all levels and listened to their views carefully whenever he found it hard to make a decision. He also sought out the views of people who were uninvolved with the earlier decisions. He also listened to people who interacted with customers and who worked in the production & manufacturing departments. It gave him different perspectives on the same problem. It helped him to justify his decision of transitioning from memory business to microprocessor business.
We have already seen that one of the strong reasons for ‘Sunk Cost’ Bias is a person’s unwillingness to admit that he or she had made a mistake.
One of the methods Andy fought against sunk cost bias in Intel is to create an environment that would not cultivate fear among employees - an environment where people would not hesitate to talk freely and share their ideas -An environment where ideas were criticised and not people -An environment where they could even question CEO’s ideas, plans and action -an environment where people were allowed to make mistakes as part of experimentation and were not punished. Without mistakes, Intel would not have developed microprocessor product. If you are not afraid of making a mistake then you will not be afraid of admitting it.
John Doerr, who had worked with Andy writes that the way to get Andy’s respect was to disagree and stand your ground and, ideally, be shown to be right in the end.
Andy was particular that CEO, department heads, managers should not be afraid of anything as that would affect other employees which in turn would affect the business. Internal fear paralyses the organisation and it will not let ideas flow from bottom to top. The fearless internal culture helped Intel to overcome some of the ‘Sunk Cost’ bias.
Many other heuristics play a major role in influencing our decisions and the choices we make. Sometimes they all work together, amplifying the errors in the decision. Most of our decisions are prone to these biases. The first step in protecting our decisions is to be aware of the various cognitive biases that reside in our brain.
Forewarned Is Forearmed -John S Hammond.
References: The Hidden Traps in Decision Making — HBR article by John S. Hammond, Ralph L.Keeney, Howard Raiffa, Thinking Fast and Slow by Daniel Kahneman, The Art Of Thinking Clearly by Rolf Dobelli, Only The Paranoid Survive by Andrew S Grove.
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