EOS is just that, an Operating System

EOS is just that, an Operating System

For those of you who are not aware of EOS, it is the Entrepreneurial Operating System. It seeks to improve businesses by getting six components aligned to enhance business operations. The six are:

  • the vision
  • the people
  • the issues
  • traction – meetings and goals (“Rocks”)
  • the processes; and
  • the data

I am a supporter of EOS in that I believe all companies should have some system to improve their performance. However, as I have worked with clients who have implemented EOS, I found that it is just that, an Operating System and not a business model that enables the organization to grow!

As defined by Wikipedia, an Operating System is “the software that supports a computer’s basic functions, such as scheduling tasks, executing applications, and controlling peripherals.” So for a business, I defined it as “a model that supports the company’s primary functions, such as identifying a vision, getting the right people in the organization, improving meetings, defining goals (rocks), etc.” At the risk of upsetting EOS Implementers®, I think EOS satisfies these metrics to a varying degree, but in most cases, doesn’t enable the company to build a growth engine.

Here is what I believe is missing to develop a growth model.

The Hedgehog Concept

In Good to Great, Jim Collins talked about the Hedgehog Concept named after Isaiah Berlin’s essay, “The Hedgehog and the Fox,” which divided the world into hedgehogs and foxes. The theme is based upon an ancient Greek parable where “The fox knows many things, but the hedgehog knows one big thing.” Collins found that those companies who became great followed the Hedgehog Concept. Those companies which didn’t tend to be foxes never gaining the clarifying advantage of a Hedgehog Concept, being instead scattered, diffused, and inconsistent. 

The Hedgehog Concept is based on the questions prompted by the three confluence of questions. 

  • What can you be the best in the world at?
  • What are you deeply passionate about?
  • What drives your economic engine?

The EOS Model® doesn’t focus on the hedgehog concept, and so many companies using EOS have goals and strategies based on bravado than from understanding.

Knowing your hedgehog concept will keep the organization focused on something that aligns its passion with what it can be the best at. Being good at something means you are only good and indistinguishable from many others. If you are the best at something, then you stand above the crowd. Finally, the economic engine keeps the company focused on a metric that drives profit.

Vision

While the EOS Method® works to develop a ten-year goal, I find that is not as compelling as Jim Collins’ BHAG. A BHAG, Big Hairy Audacious Goal, is a clear and persuasive statement and serves as a unifying focal point of effort with a defined finish line. It engages people, is tangible, energizing, highly focused, and often creates immense team effort. People “get it” right away; it takes little or no explanation. 

A visionary BHAG is a 10-25 year compelling goal that stretches your company to achieve greatness. It should be a huge, daunting task, like climbing going to the moon, which at first glance, no one in the company knows how on earth you will achieve.

As Collins’s noted, the best BHAGs require both “building for the long term and exuding a relentless sense of urgency: What do we need to do today, with monomaniacal focus, and tomorrow, and the next day, to defy the probabilities and ultimately achieve our BHAG?”

Profit/X = Economic Engine

The BHAG’s economic engine is the concept of Profit/X. In Good to Great, Jim Collins defines this strategic metric as “One and only one ratio to systematically increase over time, what x would have the greatest and most sustainable impact on your economic engine?” Unfortunately, too many companies don’t have an economic engine, so they fail to deliver hoped-for profits. This metric is not easily identified; however, Collins noticed that the companies that took the time to discuss, debate, and agree on one key driver for their economic engine are the ones that went from good to great.

Profit/X how you choose to make money; it is a strategic metric, not an operational one. This ratio is a key driver in your financial engine and when you make decisions about how to spend money. When developing your Profit/X, you need to have that is unique and not the industry average because if you choose the latter, then everyone will be pricing and driving costs the same way to maximize it. Like the BHAG, a correctly defined Profit/X will promote teamwork as everyone can focus on their role to drive the metric, from how many people to hire, where to open new operations, etc.

Here are some examples of Profit/X.

  • Profit/customer experience or customer visit
  • Profit/customer
  • Profit/employee
  • Profit/location
  • Profit/geographic region
  • Profit/part manufactured
  • Profit/division
  • Profit/sale
  • Profit/brand
  • Profit/local population
  • Profit/invoice
  • Profit/market segment
  • Profit/store
  • Profit/plant
  • Profit/purchase
  • Profit/square foot
  • Profit/fixed cost
  • Profit/recurring revenue client
  • Profit/seat
  • Profit/plane
  • Profit/product line
  • Profit/life of the customer

To frame this in a real-life context.

Southwest Airlines: Profit per plane

Walgreens: Profit/Customer Visit

New System Laundry: Profit/Delivery Truck Load

I think the EOS Method® ignores the following areas, but to me, they are part of the Hedgehog Concept. If you are doing something with clarity and focus, you need to have clarity and focus on these areas.

Value Creation

It is said, “A Business That Doesn’t Create Value for Others is a Hobby,” so what value does your organization create? Value creation is part of what you can be the best at. However, organizations need to know, “What is the problem they are seeking to solve for their customers.” Christian Claytonson defined this as “What is the job your customer is hiring you or your products to do?” Too many organizations define the job to be done as what they do, e.g., “We integrate your systems.” While that is what they do, that is not the job they are hired to do. The job they are hired to do may depend on the client but could be, “Provide information from across the organization to make better-informed decisions.” Knowing the job to be done enables your marketing and sales efforts to focus on the customers’ needs rather than on what you do. No one cares about what you do; they care if you can solve their problem. I don’t see the EOS Model®’s focus on this crucial question, but it is central to a company’s growth.

Core Customer

Who is the company’s core customer? I have discussed this before, and many companies can identify their core customer. However, most haven’t analyzed their customers from the point of view of Profit/X. If Profit/X is the driving metric of the organization’s profitability, then failing to know which customers meet and exceed it is crucial in defining your Core Customer. There is little point focusing on a Core Customer that doesn’t meet your economic engine’s critical financial metric, hoping that somehow you will magically capture the lost profit elsewhere. Furthermore, if you don’t know your Core Customer, your marketing and sales activities will be directed towards the wrong groups, further weakening your performance. 

Brand Promise

What is your Brand Promise, and how is it measured? This question is one that the EOS Model® doesn’t address. However, it is crucial.

  • It is what convinces your targets to buy from you. 
  • It is what you stand for and promise to deliver. 
  • It is the metric against which you will be measured.

Some organizations do have a brand promise, but it is not measurable. In that case, it is “valueless” because if it is not measurable, no one knows if you are delivering it, and in that case, it has no value to prospects or clients.

Value Delivery

Value delivery is vital for knowing how customers value the performance of the organization. While the EOS Model® discusses many metrics, this one does not get enough focus. Companies need to understand if their customers are satisfied with their performance. Recently, I spoke with a CEO who said that 80%+ of their customers were “Very Satisfied.” However, on further investigation, I discovered:

  • It was just a guess as they didn’t measure it.
  • 7 – 10% of their customers had complained in writing about their product and delivery in the last year.
  • None of their clients had recommended them.

Here is wishing over reality. I would expect that the company had a “Very Satisfied” score of less than 25%, and they should be working hard to improve their delivery and start collecting customer satisfaction data.

Critical Number and Counter Critical Number

The EOS Model® deals with goals (Rocks) and meetings, and that is one area that I think it does very well. However, I notice that the Rocks are not aligned to improving a critical number for the quarter. The Rocks should seek to improve some Critical Number each quarter. Without a Critical Number, you are once more a Fox, not focused. Those that use Scrums know the importance of the Critical Number. 

Rocks are great, but they need to improve a single business area to have the most significant benefit. As the saying goes, “You cannot defeat ten soldiers by sending in one soldier every day for 100 days.” For example, if our Critical Number is Customer Service in a Call Center, then the Rocks could relate to:

  • Hold time
  • Time on the call
  • Customer satisfaction at the end of the call
  • Percentage of calls resolved in one call
  • Employee satisfaction.

The Counter Critical Number is essential to preventing the critical number from overwhelming the company and leading to adverse effects. For example, if our Critical Number is project completion, then a Counter Critical Number would be customer satisfaction. This metric would counter the attempt to deliver incomplete or defective products or projects.

Focusing on a Critical Number and Counter Critical Number for the 13-Week Sprint is essential to developing focus and alignment within the organization.

Team Alignment

The EOS Model® does a great job of looking at the “Right People” in the “Right Seats.” However, what it doesn’t look at are alignment among the leadership team and employees’ satisfaction. Is your leadership aligned around the company’s direction or not? Culture will bring them to agree on values, but not necessarily alignment.

Your employees may all have the correct values, which is crucial, but if they are not engaged or dissatisfied with the leadership, cultural values will not prevent them from leaving or, worse, showing up but not there. Companies need to survey their leadership teams for alignment and their employees for satisfaction to ensure everyone is working in the same direction and committed to its success.

Conclusion

Thus while I like the EOS Model®, I think it doesn’t deal with many of the key things involved in the Hedgehog Concept. This failure enables companies to perform but not grow at an optimum rate. I am not ignoring many of his other areas of focus in Good to Great; however, this refinement of the Hedgehog brings an additional guide that the EOS Model® doesn’t. 

The above model is most of Gravitas 7 Attributes of Agile Growth® model, and if you add in the rest, you have a model that will propel you to growth while keeping your operations running smoothly. The 7 Attributes of Agile Growth® focuses on:

  • Leadership
  • Strategy
  • Execution
  • Customer
  • Profit
  • Systems
  • Talent

making it a more encompassing system. If you want to start your transition to an agile growth company as a certified Gravitas Agile Growth coach, please contact me.

 

 

Copyright (c) 2021, Marc A. Borrelli

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Profit ≠ Cash Flow

Profit ≠ Cash Flow

While I have known this for a long time, last week, it was brought home to me how many conflate the two. Profit and Cash Flow are not the same. I have known many profitable companies have negative cash flow and some unprofitable ones have positive cash flow. Knowing the difference is critical. 

As I have mentioned before, cash is the blood in a company. Without it, the company dies, regardless of how profitable it is. Many young companies that take off don’t appreciate the issue and believe that they will solve it with growth. However, this is similar to the old business joke, “Of selling at a loss but making it up on volume.”

How the Statements Connect

For non-accountants and finance people, the issue is that they look at the Profit and Loss Statement, Balance Sheet, and Statement of Cash Flows as separate entities without realizing the interconnectedness. Finally, the way a standard statement of cash flows is laid out, most don’t know what it is saying. 

It takes a while to realize that the P&L shows you the earning for the period, then the statement of cash flows shows the adjustments required to get to the cash generated from the different sources. Finally, the balance sheet is the statement at the end of the period of what is owned and what is owed. They flow in that order, generating the statement of cash flows from the profit and loss statement, and the balance sheet really cemented the relationships in my mind.

The Dates

Again, I was made aware of this when I was presented with a profit and loss statement and balance sheets, but all as of different dates. If the dates don’t sync, you can’t deduce much from them. The profit and loss statement must cover the same periods. The balance sheets must be as of the starting date and the ending date of the period. Sounds simple, but many look at these financial statements for different periods and don’t realize that you can’t tell much from them.

How to Determine Your Cash Flow

Now many people don’t understand the statement of cash flows, and I understand that. The key information is how much cash the firm generates or absorbs, what it will do with it, or how it funds the shortfall. For many entrepreneurs, here is an easy way of looking at Cash Flow. Assume your company has a Gross Margin and Net Operating Margin of 20% and a 10.15%, respectively. In addition, your Accounts Receivable, Inventory, and Accounts Payable are 80, 35.7, and 45 days respectively. If you grow revenue by $100, the effect is as follows.

Revenue + $100.00
Cost of Goods Sold 80.00
Gross Profit = 20.00
SG&A (Overheads) 9.85
Net Operating Profit = 10.15
Accounts Receivable (80 days) 21.92
Inventory (35.7 days) 9.78
Accounts Payable (45 days) + 12.33
Cash Shortfall = $9.22

Thus for every additional $100 of revenue, you need $9.22 of extra cash. This is why many fast-growing companies implode, they cannot get sufficient cash to fund their growth, and without cash, the company dies. Now some will argue that I have not added back depreciation etc. That is true; however, I have found that CapEx is equal to depreciation over time if you wish your company to keep functioning, so that is just a timing issue.

How to Improve Cash Flow?

So understanding your cash flow is a vital part of understanding the financial model of your business. If you generate a shortfall, you need to figure out how you will finance it. There are really three options,

  1. Arrange to finance for your working capital.
  2. Shorten your Cash Conversion Cycle
  3. Use the Power of One to change the cash generation of the business.

There are a number of companies that provide working capital financing, so if you need some names, let me know. If you don’t know your cash flow cycle, it is the time from when you start the sales cycle until you get paid. It is broken into four areas – Sales Cycle, Make/Production & Inventory Cycle, Delivery Cycle, and Billing and Payments Cycle. The Power of One, developed by Alan Mills, determines which of seven variables most influences increased cash flow.

I know many companies don’t have this information, and their accounting systems don’t know how to produce it. In that case, get a coach or adviser who can help you. The investment will be well worth the effort to understand how to drive your business without ongoing funding. If you want more information on how these work and how to implement them in your business, message me.

 

Copyright (c) 2021 Marc A. Borrelli

Do You Truly Know Your Core Customer?

Do You Truly Know Your Core Customer?

Who is your Core Customer?

In working with many clients on improving their business and developing a growth model, we soon get into the issue of their “Core Customer.” I have realized that many have not given this much thought and cannot easily define their “Core Customer.” Your Core Customer is the customer you are targeting, the customer that is preferred, and the one that your marketing and sales efforts are focused on. A Core Customer has the following attributes:

  • A real person with wants, needs, and fears.
  • Will buy for optimal profit.
  • Has an unique online identity and behavior.
  • Pays on time, loyal, and refers others.
  • Exists today among your customers

Not knowing your Core Customer is not a terrible problem, as we can quickly work through a session to put a definition in place. However, a more complicated issue is knowing their Core Customer but unable to define their “Economic Engine,” or profitability per customer. Lack of good data is always a severe problem! If you can’t measure something, then your performance is purely an assumption, and down that road is chaos.

Profit per Customer

If you don’t know your profit per customer, the customer you consider your “Core Customer” may generate sub-par profits pulling down the company’s performance. During a recent conversation, a CEO told me their metric was revenue per employee. While that would generate top-line revenue, it does nothing for profit, efficient customer targeting and marketing, or market differentiation. The business adage, “We are losing money on each item, but will make it up on volume,” seems to be the driving force.

Many companies I have worked with cannot tell me the profitability per customer and so work on the assumption that they are performing well, but cannot understand why they cannot scale and have profit and cashflow issues. Also, often their data is corrupted by the “Flaw of Averages.” So to paraphrase the proverb, “First get your data.” Sometimes getting good data on project costs is difficult, but without there cannot be:

  • Knowledge of performance;
  • Plans for improvement;
  • Measurement of improvement.

And “Hope is not a strategy.”

Select the Right Core Customer

Once we have data showing your Core Customer’s profitability, we can determine if they generate optimal profit. Since a requirement of a Core Customer, as mentioned above, if your Core Customer is not generating optimal profit, then there are one of two choices:

  1. Change your economic model so that they do, or
  2. Change your Core Customer.

When examining the data, many companies have found that the companies they were targeting as their “Core Customers” were their less profitable customers and ones that everyone in the market was fighting over. Targeting a different segment of customers that generated optimal profit could increase its profitability and differentiate itself from its competition, a great “Blue Ocean” strategy.

Lake Truck Lines, a Gravitas client, was focused on large customers. However, when analyzing its data, Lake Truck Lines realized that everyone was targeting those customers so there was pricing pressure and low margins. By make mid-sized customers its Core Customer, the company was able to operate with less competition and generate the optimal profit per customer. Similarly with Build Direct, focusing on young women seeking to do DIY, it was able to realize a much higher margin and operate in “Blue Ocean” waters compared to when it was focused on supplying general contractors.

The time spent analyzing your clients, their profitability, and your Blue Ocean possibilities can result in you operating at higher margins with less competition.

Profit / X

I have discussed the “Economic Engine” before, but it is the concept of “Profit/X,” Profit/X is the crucial part of your strategy, and it must:

  • Tightly aligns with your BHAG®
  • Be the fundamental economic engine of your business
  • Be a single overarching KPI to scale your business
  • It must impact revenue while controlling cost.
  • More X must be desirable.
  • It must be unique within the industry – you have to differentiate yourself from your competition.

What is critical is finding a Profit/X that is unique within your industry. If you choose the same Profit/X as everyone else, you are all competing on the same drivers, and you cannot differentiate yourself from your competition. Having identified our Core Customer, the appropriate Profit/X can be identified. Picking the wrong Profit/X given your Core Customer again will lead to sub-optimal results. These two concepts are interconnected and for you to achieve the best results, you need to determine both and have them connected.

Having the Right Profit/X

If your Profit/X is defined as profit per employee, you have only three ways to achieve this: increase the price, improve employee performance or cut the product’s quality. Since price should be driven by value creation, not employee profitability, raising prices may be difficult. We do not want to cut value delivery, and driving employees harder is no recipe for success. Thus a better metric may be profit per customer.

With customer size, if you are servicing large customers it may require longer larger projects compared to mid-sized companies. If mid-sized companies have more set up and administrative costs then your Profit/X must be different between the two.

There are many examples of Profit/X from Southwest Airlines’ profit per plane to a dry cleaner who measured it by profit per delivery truck. The key is to find the one that drives your business and will also differentiate yourself.

Conclusion

Many CEOs and Business Owners are salespeople and are not interested in digging into the financials and getting to the data I have discussed above. However, the effort is well worth it, as once you have a clear understanding of where you are, you can:

  • Target marketing towards your Core Customer;
  • Differentiate yourself from your competition;
  • Ensure that all projects, services, or products meeting your Profit/X to ensure profitability; and 
  • Position yourself for growth and profitability. 

Get your CFO, your team, and a coach and spend a day or two to determine the ideal results. The payoff will be huge.

 

Copyright (c) 2021 Marc A. Borrelli

Does Your Financial Model Drive Growth?

Does Your Financial Model Drive Growth?

Working with many companies looking to grow, I am always surprised how many have not built a financial model that drives growth. I have mentioned before a financial model that drives growth? Here I am basing on Jim Collin’s Profit/X, which he laid out in Good to Great. So then we have to delve into what is Profit/X. This is the key financial metric that drives profitable growth by defining some profit number per some “X” that results in:

Passion. Your employees are passionate about the “X” and excited about increasing it.
Empowerment. Your employees are empowered to make decisions to ensure the baseline Profi/X is met.
Drive. It drives behavior to generate profit and growth.
Discipline. It provides the financial discipline to ensure that the organization remains profitable as it grows.

Thus is it is your Economic Engine that will enable profitable growth.

Many people look for a quick answer in determining Profit/X, but there is no quick answer. It is an iterative process that will get there, but no something you necessarily come up with on the first try.

Profit can be:

  • Gross Profit,
  • Operating Profit,
  • Net Profit,
  • Gross Margin,
  • Operating Margin, or
  • Net Margin,

to name a few.

“X” is very variable and can be:

  • “Product/Service,”
  • Customer,
  • Invoice,
  • lb,
  • pallet,
  • truckload, or
  • plane.

For a better understanding of Profit/X, my video below may help explain it better.

Profit/X

It is well worth your time to develop your Profit/X and get your employees to understand it and embrace it. The discipline it provides combined with the drive and empowerment it delivers makes a very strong economic engine and ensures continued profitability through your growth.

 

Copyright (c) 2021 Marc A. Borrelli

 

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During a recent call with a CEO, we discussed the company’s profitability and what measure they used to drive profit – basically Profit/X. It became apparent that they didn’t have a handle on their costs and what they should be charging to ensure they hit their profit targets. I have addressed this a bit before to ensure that your margins were where you wanted and rejecting low-profit jobs. However, this time the issue is to understand the jobs’ profitability and price new jobs effectively.

The Costs

To determine profitability, we need to know our costs. Thus, we built a table listing every employee, the salary, additional expenses, e.g., health insurance, 401k, etc. (estimated at 35% of wages), and the amount of billable time. As a result, we had a table that looked like the one below.

Employee Costs

Calculate Hourly Costs

From this Table, we could determine the hourly cost of an employee. To calculate actual costs per hour, we took the number of billable hours, which for 2021 is 8,760, and subtracted 96 hours, the allowable PTO. However, most employees don’t work their total billable hours for various reasons, so we included a “slack” factor of 10%. For multiple reasons, most projects have “re-work” or errors that cannot be billed and estimated at 10% and included. As a result, the total “Billable Hours” was 7,800 rather than 8,760. These adjustments allowed us to produce the hourly cost for each employee.

Calculate Overall Costs

Taking that data, we then divided the hourly costs into billable and non-billable. We added fixed overhead, which was not related to billable expenses, e.g., CEO’s pay, office rent, etc. Thus, we now had a cost structure for the firm that looked as follows.

Billable Costs $1,099,150
Non-billable Costs 1,194,500
Overhead 750,000
Total Costs $3,043,650

Calculate Revenue

With the company’s cost structure defined, we could determine how much to markup hourly costs to make a 25% profit. Doing this analysis is easy in Excel; however, ensure you don’t make easy Excel mistakes. , and the result was that marking up hourly costs by 232% would enable the company to meet its profit goal. This analysis is shown below.

Revenue $4,056,895
Total Costs 3,043,650
Profit $1,013,245
Profit Margin 25%

 

Pricing of new projects

While I am a strong proponent of selling value, not time, if the company wants to know the minimum price to charge to realize its minimum profit, it can use this data. Identifying which employees will work on the project and for how long. For example, they would be able to cost it as follows:

Employee Hours Hourly Billable Rate Total Billable Charge
#3 25 $49.32 $1,233
#6 5 44.77 224
#10 20 43.83 857
#15 15 30.50 457
#17 10 48.67 487
Total     $3,258

With this data, we can now estimate jobs more effectively since we know the employees who will work on the jobs and how many hours they will commit. We have to build some waste into that model, but we have a good idea of how to price jobs.

 

Performance Table

Also, we can see either weekly, monthly, or quarterly how the company is performing. If we produce a table of the employees and clients and hours worked for a month, we can see the utilization of each employee and profit per client as follows.

Employee Utilization and Job Profitability

This table provides a good insight into the company’s and employees’ performance. As can be seen, Employees #3 and #6 are working more than their billable hours with utilization rates above 100%. While this may be good, one would need to ensure that whatever they were supposed to be doing with their non-billable time was being done. Also, Employee #9 is utilized 71.3% of the time, resulting in lost efficiency. Further analysis is required into why this is the case, but it identifies potential issues. Finally, it would appear that nearly half of the employees are working at less than 95% utilization. Given that the company’s utilization is already adjusted for “Slack” and “Rework,” analysis to understand why utilization is low is required.

We cannot only analyze employee performance, but we can see how we are doing with our various contracts. Clients #1 and #3 are losing money, while Client #4 is profitable. The data doesn’t tell us why, but again that would be work investigating as the company is performing below its goal of 25% profit.

Conclusion

As I stated at the beginning, concerning pricing, I strongly believe in pricing according to value and not hours; however, this analysis and methodology are helpful to understand what an organization’s minimum pricing should be and how it is performing. While several issues are highlighted and require more work, this provides a great way of knowing what to examine to improve performance.

If you would like to do this analysis, call me. I would be happy to help you.

Copyright © 2021, Marc A. Borrelli

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Sunk Costs Are Just That, Sunk!

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Working with my Vistage group this week, we had an exciting discussion about “If you were starting your business today, what would you do differently?” This discussion made me think of sunk costs and how they limit us. I have discussed how to make better decisions before, but sunk costs deal with our assumptions.

What are sunk costs? A sunk cost is a payment or investment that has already been made, and it is sunk because it is unrecoverable no matter what. So, it should not be a factor in any decisions from now on.

The Sunk Cost Fallacy

The sunk cost fallacy is when an action is continued because of past decisions (time, money, resources) rather than a rational choice of what will maximize the returns at this present time. The fallacy is that behavior is driven by an expenditure that is not recoupable regardless of future actions.

For example, a company that decides to build a new software platform. They have done their analyses and determined that the future benefit they will receive from the software will outweigh its development cost. They pay for the software and expect to save a specific cash flow level from the software’s production each year. But after a few years, the platform is underperforming, and cash flows are less than expected.

A decision has to be made: should the platform be abandoned or not? At this point, the software’s initial cost is a sunk cost and cannot be recovered. The decision should only be based on the future cash flows—or the future expected benefit—of the platform compared to the value of replacing it today, not the original cost of the software.

However, businesses, organizations, and people often have difficulty abandoning strategies because of the time spent developing them, even if they aren’t the right choice for the company or individual. Therefore, recognizing what a sunk cost is will result in better decisions. 

How sunk costs sabotage us

Here are a few ways, but this list is not exhaustive.

At Work

Bad Pricing

Companies often justify pricing based on their costs. Most commonly, the R&D expenditure to develop the product. Whatever the R&D costs were, they are irrelevant to the pricing. The market will only pay what the product is worth, not what was invested in it. A pharmaceutical company’s attempt to justify high prices because of the need to recoup R&D expenses is fallacious. The company will charge market prices whether R&D had cost one dollar or one million dollars.

Similarly, many businesses price their services on the hours it took to deliver a service. However, the costs of providing the service are sunk, and you cannot recoup them. The market will only pay you what they deem the value of the product or service to be, so using pricing to recoup costs is “backward.” Instead, one should determine the price and then figure out how to deliver the product or service at the profit margin desired.

Consider if a company invested $100,000 to produce a product and planned to sell them at $100 each. However, the day after the product launch, a competitor announces a better competing product at $50. Will anyone pay $100 for an inferior product when the best one is available for $50?

Bad Investments

Sunk costs are why so many investors tend to remain committed or even invest additional capital into a bad investment to make their initial decision seem worthwhile. How many times has an investor tell you, “As soon as X gets back to what I paid, I am selling.” Why?

What they paid is paid. The investor cannot change that; it is a sunk cost. The real question is, “Does X offer higher returns in the future than Y, some other asset I am considering, after transaction costs?” If yes, then stick with it. If no, switch out X for Y. 

Assume you spend $4,000 on a wine tour of Napa. Later on, you find a better wine tour to Bordeau that costs $2,500, and you purchase that trip as well. Later, you realize that the two dates clash and the tickets are non-refundable. Would you attend the $4,000 good wine trip or the $2,500 great wine trip? The $2,500 trip. The $4,000 trip is irrelevant in consideration because it is inferior, and the money is gone.

Bad processes

Returning to my initial question, “If you were starting your business again today, what would you do differently?” Many people will give outstanding examples of what they would do differently but never consider making the change because of the investment they have in their current process. As with assets, if your current process generates a cash flow of $X per year, and switching would generate some cash flow greater than $X after the costs of switching, you should switch.

Misaligned employees

Many companies have employees whom they know are subpar. However, they cannot fire them because they have been employed for a long time or the company has invested some amount in them. This situation is most often seen with those employees who have been with the organization since the beginning. However, the organization has outgrown them. 

Again, the time invested by the company and the employee are sunk costs. The decision is what is the best investment going forward. If a more significant return is achievable with a new employee, then the change is required.

Sunk Costs Exist in Our Personal Lives Too

Feel free not to ski in bad weather.

You may be considered a fair-weather skier, but the cost became sunk when you purchased your ticket. You might feel obligated to stay and stick it out if the ticket was expensive or you have a limited holiday window, but if not skiing in a freezing whiteout makes you happier, do it! Either way, you aren’t getting your money back.

Don’t go to the gym just because you have an annual membership.

While working out may be advantageous to your health, your annual membership shouldn’t dictate whether you go to the gym on any given day. If you have paid up front, then the money is gone. So if you would prefer to take a hike, ride a bike, relax and meditate, you should. However, I am not saying there may be more benefits to working out.

Don’t grow up to be a lawyer.

I chose lawyers because I was this example; however, I decided before I graduated law school that I didn’t want to be a lawyer. Assume you went to law school, passed the bar, started working, and then realized you hate being a lawyer. What should you do? You invested so much time, energy, and money in that degree, so it can’t be worth starting over again with a new career? Unfortunately, time, energy, and money are all sunk costs, so if your end goal is your happiness, you might need to cut your losses and refocus your energies elsewhere. 

With the above examples, next time you face a decision, ignore all the sunk costs; you will make better decisions for your organization and yourself.

Copyright (c) 2021, Marc A. Borrelli

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