Guts, Part Four: Sunk Costs and Divesting

If you’ve been doing something for a while, and now you change course, is that an admission that the way you were doing it before was a mistake? If you’ve spent a lot on something, should you toss it out when something better comes along? If your budget is full of “keeping the lights on” costs, should that keep you from investing in innovation instead?

Sometimes, you need to free your company from the past. In keeping with the theme of this series, I’ll tell you that it can really take guts to do so. In earlier posts, I talked about the guts to make decisions based on limited information, the guts to insist on high standards from vendors, and the guts to push back on senior executives who disagree with you. In this post, I’ll talk about having the guts to change decisions you’re already invested in when doing so would be in the company’s interest.

The Sunk Cost Fallacy

The sunk cost fallacy is the mistake of continuing with something you’ve already invested in because you don’t want to lose your investment to date, when there are other options that will give you a better return on your incremental investment. Let’s say that you’ve invested a million dollars in a mainframe computer, and it costs you $100,000 every year to maintain it (I’m making these numbers up). Let’s also say that you can get the equivalent compute power for $80,000 a year in the cloud. Should you dump the mainframe, which you’ve already sunk $1 million into, and just move to the cloud?

Uh, yeah. The million-plus dollars you’ve already sunk have no bearing on the decision you have to make. All that matters is the $100,000 per year for the mainframe versus the $80,000 per year for the cloud. (I’m not an accountant—there may be GAAP reporting or tax implications I’m missing here. I’m just trying to give an example of the sunk cost fallacy). The important point is that in making a decision, you have to consider the future cash flows, not the past.

Yes, you might feel a bit stupid abandoning something you’ve paid a lot of money for. Go ahead, feel stupid. But make the decision that’s right for the company. And if someone questions you, explain the sunk cost fallacy to them, or ask them to look it up.

The Whoops! Syndrome

I don’t know if there’s a better name for this. What I mean is the fear that people will criticize you for a decision you made in the past if you change direction now. I almost said “if you change the decision.” But that’s not necessarily what you’re doing. You’re really making a new decision with the new information that became available since you made the last decision. In my book, that’s a different decision.

Now, it might be that your last decision actually was a stupid one. If so—accept that you made a mistake, and correct it now. But if you made a decision that was right at the time and circumstances have changed—you should also correct it now! Either way, it’s important to have the guts to change course if changing course is best for the company.

When I was a government CIO…well, government is special. Every decision you make is scrutinized by the press, Congress, the GAO, OMB, Inspectors General, lobbyists, and someone’s grandmother in rural Nebraska. When a CIO before me bought a whole lot of licenses of a COTS product and tried to integrate it with 28 other COTS products to build a new system—and the integration was disastrously difficult and was way over budget and behind schedule with no end in sight—the right thing to do (in my judgment as CIO) was to dump the licenses we’d already paid for and start again with a new architecture.

We knew we’d hear no end of it from the press, Congress, the grandmother in Nebraska, and all the rest of those folks. And we’d look really bad. Nevertheless, the right decision is the one that looks forward, the one that, with integrity, tries to get the best possible results with any incremental resources that go into the initiative.

Keeping the Lights On

It’s a cliché in the IT world that <go ahead and put some huge number here> percent of every year’s budget goes to just keeping the lights on—spending that’s nondiscretionary and includes things like maintenance fees for software you own, support fees for hardware you own, fees for electricity and air conditioning and software upgrades and maintenance of software you’ve built yourself and on and on. The problem, according to the conventional wisdom, is that that leaves very little of the budget available for innovation and delivering “business value.”

I’ve always been uncomfortable with this line of reasoning. “Keeping the lights on” spending—obviously—does add business value. Without it, you wouldn’t be able to run the business. And a bunch of that “maintenance” spending is actually better classified as innovation spending, because it often means changing your software as your business changes, or incorporating new features and security improvements as your vendor releases them.

But all that aside, and keeping with our theme, it’s often misleading to think of these costs as nondiscretionary. That’s really another version of the sunk cost fallacy. You don’t have to pay the vendor maintenance and support fees for a piece of software or hardware—you can choose to stop using it instead. You don’t have to pay for your datacenter’s electricity and air conditioning—you can move to the cloud instead. I’m not saying you should necessarily stop any of these things—the decision is yours and depends on your circumstances.

I mean that these costs are discretionary like any others, and by paying them, you’re affirming that they add value for the business. You choose them anew every year. Or, you can choose not to pay them and to find an alternative. Your sunk costs don’t matter—it’s a question of deciding what spending this year will give you the best results. The best thing to do might be to toss something you’ve already paid a lot of money for, if there is an alternative that will yield a higher return on the money you spend in the future. It’s reasonable to divest assets—even expensive ones—when doing so avoids unproductive spending in the future.

If you decide to stick with what you have, then you’ve made a choice about how to spend your money. So don’t complain that you have a fixed overhead—you’re choosing that overhead yourself. Either way, make a good decision and then have the guts to defend it. Don’t eat spoiled food just because you paid money for it.

Conclusion

Decisions about future spending must be made without emotional commitment to past spending. Even if they’re made well, you might look wishy-washy. You might be questioned on whether your old decisions were mistaken. You might give up something you’ve grown comfortable with. It doesn’t matter. Just do what’s right.

—Mark
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More on this topic

Guts, Part Three: Having Backbone – Disagreeing and Committing, Mark Schwartz

Guts, Part Two: Working with Vendors and Contractors, Mark Schwartz

Guts, Mark Schwartz