Sunken Cost Fallacy/Escalation of Commitment

            The business world is full of cases of the sunken cost fallacy.  A company will invest in new equipment or technology, sometimes with a significant amount of cash or debt, and then do anything they can in order to maximize the utilization of their investment, even when it is the wrong solution.  Businesses do not want to be wasteful and they do not want to regret their previous investments, so sunk cost is a very human reaction (Ducharme, J., 2018).  Sunken cost is also referred to as escalation of commitment and is seen when people continue following a failing path even after information shows that it is the wrong path to follow (Bauer, T., Ergodan, B., 2010, p.252).  We see sunken cost in the information technology industry constantly.  Servers, firewalls, switches, and software licenses are all very expensive.  Software development is very expensive.  Companies are reluctant to throw a previous investment away, even when it proves to be the wrong choice.  The most agile method to approach business decisions may be constant experimentation and failing fast, then pivoting quickly to the next strategy.  In reality, especially with IT, companies are reluctant to give up their current investments.

XYZ Corporation

            XYZ Corporation (anonymized to protect the innocent) is a 10,000 employee company that rents table clothes, uniforms, curtains, and other linens.  The have taken a mobile-first approach to sales that enables their customers and supply chain via a mobile application that they have written.  They serve their custom-developed application from their datacenter.  Thousands of servers, costing millions of dollars, serve this application to the Internet.  Millions of dollars in high-end storage serve this application and host its database.  The storage and servers are “refreshed” (upgraded and purchased new) every three to five years.  Enterprise licensing agreements for VMware and Microsoft licensing cost the corporation millions every year.  Add in firewalls, routers, switches, and security, and the price continues to climb.  They have power conditioners, battery backups, and generators.  They have massive redundant air conditioners in their datacenter.  They have expensive fiber trunks coming into their datacenter from multiple Internet carriers, providing the bandwidth for their application.  Total infrastructure costs, including licensing approach $100 million every year.  On top of this, there is an IT team of around 1000, including developers, designers, and infrastructure specialists.  With an average salary of $80,000/year, the cost of the IT team is $80 million every year, plus benefits.

            Note that XYZ Corporation is a linen rental service but has around $200 million invested every year in their development and infrastructure.  Their application handles E-commerce, EDI to vendors and supply chain, customer ordering, inventory management, and billing.  Although it is custom developed, the application is made to be generic and modular to accept any companies that are acquired through M&A activities.

            Oracle NetSuite comes to market and does literally everything their app does, is completely cloud-hosted, and costs $99/user/month.  Across 10,000 employees, that amounts to almost $12 million per year.  Most companies spend less than $100,000 on NetSuite implementation.  Even if XYZ Corporation went above and beyond, a fully customized NetSuite implementation would cost less than $1 million.  Annual consultant and training costs would add another $1 million.  So, all in, XYZ Corporation could move to Oracle NetSuite for around $13 million/year.

            XYZ Corporation’s C-suite executives met and decided that the capital they have invested in their datacenter, servers, software, and development is too great to throw away.  Even if adoption of NetSuite could be done in as little as 1-2 years, they decided that they will continue to develop and support this core application.  The argument that XYZ Corporation has is “we’ve already trained everyone and spent the time, money, and energy developing this.”  After reviewing Oracle NetSuite, XYZ Corporation has identified a lot of features that they want to add to their own app, so they are hiring more project managers, designers, and developers to add those features to their existing investment.

            XYZ Corporation continues to buy new servers every 3-5 years, buy new storage and upgrades every 3-5 years, and pay licensing, development, and management costs every year.  They have now escalated their commitment by hiring more designers and developers to make the product as polished as the solution that they would buy ready-made from Oracle.  Their total costs are 15x higher than if they had gone to a cloud software-as-a-service (SaaS) solution like Oracle NetSuite.  The linen company is heavily invested in being a datacenter hosting and application development company, and their continued investment shows that they would rather hold onto and improve their previous commitment than improve their business position.

Conclusion

            XYZ Corporation is a typical example of escalation of commitment.  Their company is not in jeopardy and they are not risking failure, but they are missing out on additional profit and adding value to shareholders while reducing risks from internalizing their infrastructure and development.  Tim Weber’s article on BBC said “Cloud enthusiasts like JP Rangaswami, chief science officer at Salesforce.com, one of the earliest firms to bet on the cloud, wants companies to ditch their legacy systems much faster. ‘It’s the sunken cost fallacy,’ he argues, where IT departments feel more comfortable supporting old mainframes and enterprise software instead of supporting their company’s business strategy” (Weber, 2011).  So, companies are afraid of going to the cloud because they are afraid of wasting their on-premises investments.

References

Bauer, T., Ergodan, B. (2010). Organizational Behavior, Version 1.1.  Licensed under Creative Commons.  Flat World Knowledge.

Ducharme, J. (2018). The Sunk Cost Fallacy Is Ruining Your Decisions.  Here’s How.  Retrieved from https://time.com/5347133/sunk-cost-fallacy-decisions/

Weber, T. (2011). Cloud computing: How to get your business ready. Retrieved from https://www.bbc.com/news/business-12779201

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