Some years ago I was working “The World of Concrete” (a giant, international trade show held annually in Las Vegas) for a software company offering a product to the industry.
I approached a well-dressed man coming by our booth and asked him if his company would be considering a new ERP (enterprise resource planning) system in the near future. I have never forgotten the conversation that ensued.
“No. No. We’re just wrapping up an SAP implementation now,” he replied to my inquiry.
“Well,” I said with a big smile, “allow me to shake your hand. You deserve congratulations! There aren’t that many companies I’ve heard of that have actually ‘wrapped up’ an SAP implementation.”
A smile broke across his face briefly, and then he said more solemnly, “To tell the truth, there are still some things that aren’t working quite right, yet. But, we’ve spent so much already, that it’s got to work now.”
That last part really stuck with me. It openly exposed a common bias with which we are (nearly) all afflicted.
Some have referred to this as “the sunk cost bias.”
The Sunk Cost Bias
To bring this closer to home, imagine that you recently made a major purchase—say, a new car or an expensive dining set for your home. However, after a short period of ownership, you have discovered defects or deficiencies that have led to great disappointment. How difficult would it be for you to admit your error, sell what you’ve purchased at a big loss, and take a new direction with your car or furnishings?
After all, selling your faux pas means admitting your error in judgment. However, admitting such errors in judgment is typically a very hard thing to do.
Standard economic theory tells us that sunk (irrecoverable) costs should be ignored when making decisions, because what has been spent in the past is irrelevant to the future. One cannot un-fry the egg.
What we should be considering are only the costs and expenses that are to be incurred going forward. This seems logical, but our churning gut over the money we’d be admitting we have “thrown away” just won’t seem to let us do it.
Many supply chain executives and managers continue to incur expenses month-after-month, year-after-year, by spending over and over on unpromising activities that support methods that have long ago proven themselves ineffective. They plan, then re-plan, then spend big dollars month after month supporting a vast array of firefighting and expediting activities patching up the departures from their already expensive plans.
The sunk cost bias is more devastating to organizations than most estimate. While it may not lead to the immediate demise of companies and supply chains, it too frequently keeps them mired in mediocrity.
Theory of Constraints thinking helps us overcome this strong bias by reducing our calculations to “approximately right” estimations of three factors forward-looking only:
- Changes in Throughput (where Throughput is narrowly defined as the difference between incremental revenues and truly variable costs, or TVCs)
- Changes in Investment (including changes in inventories, for example), and
- Changes in Operating Expenses (which picks up everything not include in TVCs)
Think boldly about what might change—throwing away that “old car” with which you are so disappointed. Then, make the calculations above about your bold plan to change. This should help relieve your sunk cost bias.
Have you thrown too much money into an ERP system that isn't working for your company? Let us help you get out of the sunk cost trap by switching to a more cost-effective, agile system.
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