Monday, March 16, 2009

Sunk Costs and Loss Aversion

Sunk costs are generally defined as costs incurred before that are not recoverable and should not be taken into account in decision making. Here is a slightly modified example of a sunk cost of Jerold Zimmerman "Accounting for decision making and control" (Irwin McGraw-Hill)

Example. Abadabba Berman, the comptroller of the company to cement shoes Schultz, with Microstiff has contracted to design an accounting software package owned by the company at a cost of $ 15,000. Abaddaba reasons that have invested heavily in the old system of simply abandoning it.

Abaddaba must consider the past, investment in software Microstiff face a sunk cost. According to the theory of cost only to consider the relevant costs are future costs associated with each option. If Microstiff maintain the software is more expensive than buying in the future Quickcrooks package Microstiff then the software should be abandoned. The previous large investments in Microstiff should not be a consideration in making its decision.

Loss Aversion: Why Will not Let Go Abaddaba of Microstiff

According to the theory of cost accounting Abaddaba the option of staying in Microstiff is irrational. The best option for the company is leaving the software, not keep it. Now, of course, irrational choice for business can be a very rational person Abaddaba. Why? Abaddaba not before treating investment as irrelevant is a very common feature of a behavior known as prevent the loss.

Loss Aversion varieties

For most people, losses loom larger than gains. Variations of loss aversions are common place in business and investment. For example, investors are generally much faster to gain to lose. The loss of an automatic stop when shooting a stock sale of investments of price falls to a certain extent. It is automatic and is used because it is too human trait of loss aversion that often keeps people from cutting their losses. I told you what the dollar impact of keeping the old software versus the purchase of new software would be. The tendency to hold on to losers, and therefore not cut our losses, can be reinforced by the ambiguity surrounding the decisions of the real world. If you are able to be emotionally invested in a bad decision, the tendency is to filter and skew the data to support the abandonment of courses of action are invested in.

Tips for dealing with sunk costs and loss Aversion

First recognize that there is no way to separate yourself emotionally from the consequences of major decisions made. If you own a small business, it is important to have an external consultant. Trade or business associations often have staff available for advice on business operations. Remember also the loss-aversion and an unwillingness to abandon sunk costs may be in groups as well as individuals. Ignoring the non-recoverable costs required to admit we made bad decisions.

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