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The impact of sunk costs and relevant costs…how to make business decisions

[This post is part of a series on business…for business owner/managers and their lenders.]

Have you ever made a decision because of what you have already ‘invested’? My favorite personal example is car trouble. ‘But I just replaced the engine!’ you howl as you find out the transmission needs to be replaced.

The only way that the replacement of the engine is relevant is how it might affect future costs. The fact that you just dumped $1,000 into the car is not relevant!

Today I was reminded about sunk costs in important decision-making.
Thumbnail image for Thumbnail image for Thumbnail image for Thumbnail image for Thumbnail image for BankerKayakWhiteBackgroundSmall.PNGFor my kayaking readers, here was the plan for the day. [Or you can skip this paragraph and still learn the lesson.]

  • 12NM (nautical mile) paddle out of Fair Harbor, WA.
  • Circumnavigate Reach and Stretch Islands.
  • Cross Case Inlet (1 NM) and explore, then return.

A check with NOAA that morning gave us this forecast: SW Winds 10-15 KT (Nautical miles per hour, also called ‘knots’), waves 1-2 feet. Possible showers and TSTRM (thunderstorms) in the afternoon.

Thunder and lightening…
At 7:40am there was thunder and lightening…the storm had come early. Kimberly and I decided to go anyway and see if by the time we got there one hour later conditions had improved.

How tall is this Porta-potty?
Before hours in a kayak, a trip to the Porta-potty is in order. (Can I really write this in a blog. Hmmmm. Oh, sure!) As I sat there I heard a tremendous clap of thunder seemingly right overhead. I wondered for a moment if lightening would choose the Porta-potty to go to ground. How embarrassing.

All the reasons why we should go on the paddle anyway…
Our trip leader, Bob, was influenced by many things. Several people had rented boats. For two, it was the qualifying ‘experience paddle’ that would allow them to graduate from our sea kayaking class. We all had driven over one hour to get there.

Bob thought he could modify the paddle to eliminate the crossing, the greatest threat of a lightening strike. The wind had just died down, the clouds seemed to be parting. We decided to go to a restaurant for coffee and give the storm an hour to move on…or not. Then we would decide.

Lightening.pngIt was beautiful!
The last time I saw such a dramatic thunder/lightening storm was over the Great Salt Lake in Utah. Loud thunder so close that our coffee cups rattled. We canceled.

The lesson of sunk costs…
Sunk costs represent money, effort and/or time already invested that will not change no matter what you do next.

  • Renting the kayaks and the hassle to get them…sunk costs.
  • Getting up at 6:15am on a weekend morning…sunk costs.
  • The hour drive to Fair Harbor, WA…sunk costs.

Relevant costs…what matters
These are costs that vary among future alternatives. Our alternatives were to:

  • Take the trip exactly as planned
  • Circumnavigate both islands but either skip or reassess the crossing when we had finished with the islands
  • Wait to make the decision until we had better information
  • Cancel the trip and head for home at 9:00am

The only relevant costs were the impact of a delay (on current, tide or predicted weather) and the risk of injury or death. Gee, put it that way and we would have been foolish to get in the water at 9:30am.

The pressure’s on…
As our trip leader, Bob felt bad that many of us had traveled over an hour to get there, rented boats, and counted on this trip to graduate from our class.

What pressure are you sometimes feeling that influences you to make a decision that is not for the best? I find the emotional pressure of sunk costs is extremely difficult to overcome. And in fact, sometimes your boss may not understand this concept!

You will make better decisions, in business and in life, when you use the idea of relevant costs and refuse to be influenced by sunk costs.

About the Author
Linda Keith CPA is an expert in credit risk readiness and credit analysis. She trains banks and credit unions throughout the United States, both in-house and in open-enrollment sessions, on Tax Return and Financial Statement Analysis. She is in the trenches with lenders, analysts and underwriters helping them say "yes" to good loans. Creator of the Tax Return Analysis Virtual Classroom at www.LendersOnlineTraining.com, she speaks at banking associations on risk management, lending and director finance topics.