Friday, February 10, 2006

(Ir)Rationality and Corporate Madness

The only course that I managed to get an A grade in my illustrious career at B-School was Cost and Management accounting.

And here I am in the danger of losing my annual performance incentive. My sin? I have been vehemently arguing in favour of putting into practice something I learnt in Cost and Management accounting.

Serves me right for deviating from my general philosophy of not taking academics too seriously. I sometimes wonder if performance at work and grades at an MBA are negatively correlated. But more of that later.

In my years spent in the corporate world (and in life in general) one of the concepts I have found most appealing and yet the one concept that I find most difficult to put into practice is the notion of sunk costs.

Very broadly, while evaluating the pros and cons or more mathematically the costs and benefits of a decision I should only consider future costs and benefits. Costs that have already been incurred and benefits already reaped should not enter the equation at all. It will unnecessarily cloud my decisions.

Intuitively the most rational of us make this mistake. I make this mistake often, but am puzzled that on a few occasions that I don’t; my bosses in fact mock me.

Some common examples are

1) Let’s say there are two stocks that I own,
a) I own 1 Share in Company A, Purchase price = 50, Current Market Price = 75
b) I Own 1 share in Company B, Purchase price = 100,Current Market Price = 75

If I need 75 urgently and I want to sell only one of these then which one should I sell?

Similarly

1) Total Revenues from Project A = $ 10 Million, Costs = $ 8 Million, Should I fight a battle with my customer to make an additional 1 million in revenues in the process incurring a cost of 3/4 a million?
2) Total Revenues from the same Project A = $ 8 million, costs = $ 10 million, should I fight a battle to make an additional 1 million in revenues incurring a cost of 3/4 a million?


The key to making the correct decision, I was told by my professor back in B-School, is to ensure that we only take into account future costs and benefits. One million in additional revenue vs. three fourth of a million in costs.

Put simply our decision to go ahead and contest the case or not should not be clouded by the costs already incurred.

I can bet my bottom dollar that all the bosses in the 10 companies I worked for will be more inclined to say “No” in case 1 and “Yes” in case 2

They would have certainly flunked Cost and Management accounting. But does it really matter? They decide my annual performance incentive, rationality be damned.
Authored by Sameer Nair

4 comments:

Anonymous said...

Very enjoyable reading. Very pertinent point. Great snapshot of human behaviour.

Anonymous said...

Well written post, Sameer Nair!! Cost and Management Accounting is an important course. However, there are business concepts where sunk costs really don't matter, like the Internet world, where if you have the right concept and great execution, your margins can explode and sunk costs become a non-issue.

Pankaj said...

Interesting, as usual. Its really amazing how simple it is to appreciate the concept of sunk cost, and how difficult to put it in practice. Given such rationality, no wonder economics is such a "dismal"-performing science.

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