As Peter Drucker stated long ago, “What gets measured, gets managed.” Metrics matter: they drive behavior.
Consider a company trying to stay alive in a declining market with obsolete technology: it can be done, but they probably should not make share gains one of their measures of success. Conversely, the leader in a new, rapidly growing, rapidly changing market might not want to lean too heavily on cost control metrics, which could undermine their ability to adapt nimbly.
With this in mind, Sopheon’s Michael Tulaney recently presented a webinar in which he challenged the orthodox view that financial decisions should always exclude sunk cost. A sunk cost is one that has already been incurred and thus cannot be recovered. What has already been spent, management theory argues, should not be considered when considering future expenses. The enterprise should focus on maximizing returns on expenses/investments that can be controlled – e.g., future ones – rather than engaging in the “sunk cost fallacy” in which good money is thrown after bad to justify past decisions.
While this is certainly correct in theory, the webinar argued, consider the real world behaviors it might drive in the area of innovation project management.
I once had a colleague who was frustrated because she had never launched a new product. While reviewing some discouraging data that had just come in on her latest project, she exclaimed, “We’ve got to get this out the door or my career is over!” Her solution: accelerate spending so that by the next management portfolio review, the project would look good when excluding sunk cost.
One of the philosophical underpinnings of Stage-Gate® process design is that project risk should be managed by deferring commitment of expensive resources until some of the project uncertainties have been reduced. At each successive stage, there should be less uncertainty as various questions get answered, and thus there is less risk in committing more resources. But if a manager knows that sunk costs will be excluded from future management decisions, he or she may feel incented to commit resources at an earlier, riskier stage.
Another real-world consideration is how to evaluate project success during post-launch reviews. Should project NPV be reset each time sunk costs are excluded from a decision? How do we evaluate a project that fails against going-in assumptions but succeeds against later assumptions that excluded sunk costs? This is not an academic issue, as future policies and strategic choices are built on the organization’s learnings from past projects.
Mike and I are certainly not arguing for always including sunk costs in project analyses and decisions; the sunk cost fallacy is real. But likewise, we do not believe they should always be excluded. What is needed is a balanced approach that may help to avoid incenting spending acceleration. Portfolio decisions should acknowledge failure to achieve going-in assumptions, but at the same time should be based on rational, forward-looking criteria. This is a case for both, not either.
This post has discussed one example of how a key metric can drive managerial behavior in an undesirable direction. Sopheon Innovation Management Consultants are experts in partnering with their clients to identify an optimal set of decision-supporting metrics. We would love to talk with you about your critical issues.
Key consideration: Has your company debated which financial metrics are critical for analyzing NPD efforts? What have you decided regarding sunk costs and what have been the repercussions?