Sunk Costs, Trashy Novels and Good Behaviour

Anyone working in finance is likely to be familiar with the concept of a ‘sunk cost,’ but the idea has some interesting wider applications.

The term describes an expense that has already occurred and should therefore not be considered when appraising the costs and benefits related to a possible investment or project. For example, if a pharmaceutical company has spent £500m developing a drug which would then cost £100m to manufacture and generate £400m in sales, the decision over whether to manufacture would be based only on the latter two figures: £400m sales less £100m costs would give a £300m profit. The £500m spent on development is considered a ‘sunk cost’ and so doesn’t form part of decision over whether to proceed. While in this example the outcome is clear, the concept of a ‘sunk cost’ is somewhat non-intuitive.

Outside of finance, the idea gets little recognition, but it can be just as useful in making decisions. Often people ignore the fact that an expense already incurred is a sunk cost, and as a result may not make the best use of their time or their cash. Have you ever done the following?

• Been to a show or event or on a holiday just because you had bought the tickets, even when you didn’t feel like doing it anymore?
• Sat through a movie you realised was rubbish or finishing read a book you weren’t enjoying, just for the sake of getting to the end?
• At an ‘all-you-can-eat’ buffet, eaten so much you felt sick?

A clear indicator of someone ignoring a sunk cost is when they say, “but… I want to get my money’s worth.” But this is a logical fallacy if it means continuing with something you wouldn’t otherwise do.

On the flip side, the concept of a sunk cost can be used to encourage positive behaviour. In fact by realising that we feel compelled to “get our money’s worth” we can manipulate ourselves into healthy or beneficial activities. My favourite example of this is my monthly gym membership. Based on my average attendance at the gym twice a week, it would cost the same to either pay a monthly subscription (with unlimited use) or pay individually for session I attend.

From one point of view, paying ‘per session’ gives me added flexibility by not being tied into a monthly contract (in economic terms I have “option value”). However, I know that if I pay a marginal sum for each session this gives me a disincentive to go to the gym. And if I pay a monthly subscription, I feel compelled to go, in order to “get my money’s worth,” and so I'm using this little behavioural bias in my favour.

So next time you go to a buffet, just remember it’s “eat as much as you like” and not “eat as much as you can:” it’ll save you the indigestion and won’t cost you a penny more…

The Four Hour Work Week: redefining success

Further to my last post on Richard Koch’s “The Star Principle,” I have also recently read a much more widely known book, “The Four Hour Work Week” by Timothy Ferriss.

The Four Hour Work Week (aka The 4HWW) takes a more revolutionary approach to seeking success than The Star Principle. It describes in detail the four steps you need to take in order to free up your time, yet maintain an income level that will let you live comfortably (preferably travelling the world). The book’s subtitle is “Escape the 9 to 5, Live Anywhere and Join the New Rich” and as unlikely as that sounds, the text is an audacious step-by-step how-to guide to do just that.

Step 1 Definition: Start out by getting rid of your preconceptions about what is and what is not possible. Define your dreams – and define what is ‘worst thing that could happen’ if you gave up your job to go and pursue them. If the subsequent steps go right, you won’t need to give up your income. But you have to realise that you could start again from scratch if you needed to.

Step 2 Elimination: This is a set of tips and techniques to multiply your productivity. Much of this will be familiar ground to people who’ve read other business classics – the “80:20” principle makes an appearance, as does the importance of not mistaking urgency for importance and the amount of time that can be saved by not reading the news. Ferriss is an advocate of ‘batching’ activities like checking email, voicemail and social networks – cut it down to once a day at first, then once a week.

Step 3 Automation: Ferriss’s sees the aim of entrepreneurship as ‘Income Automation’ rather than building a business empire. This is a notable divergence from Koch’s approach in The Star Principle, which is about building the biggest business possible. This step outlines how to start an online business with relatively little risk, using Pay-per-click advertising to assess demand for a product, then outsourced production and distribution to scale it up. For a budding entrepreneur it contains lots of hints and tips and although it doesn’t make it sound easy, it does come across as achievable.

Step 4 Liberation: This section of the book addresses the part of the title ‘Escape the 9-5 and Live Anywhere.’ Ferriss gives some tips on negotiating a remote working arrangement, and then how to live abroad on a low budget. He recommends taking successive ‘mini-retirements,’ on the basis of ‘why save it up to the end of your life?’

Rather than set out to make you wealthy, the main aim of Tim Ferriss’s method is to free up your time. It is less about becoming a millionaire than about living like a millionaire.

“$1,000,000 in the bank isn’t the fantasy. The fantasy is the lifestyle of complete freedom it supposedly allows. The question is then, how can one achieve the millionaire lifestyle of complete freedom without first having $1,000,000?”

I am more sceptical about this book than I am about The Star Principle. But this message – that the success should be defined in terms of lifestyle and not net worth – is a powerful one that it is easy to forget.

Richard Koch's The Star Principle: the Business of Winning

I recently read “The Star Principle” by Richard Koch, (businessman and the author of “The 80/20 Principle,” one of my favourite books). In it, he describes a powerful and convincing recipe for identifying successful businesses. I can recommend reading the book but for those who don’t have the time here’s my summary of it:

A star is defined as a business which is the #1 player in its market niche, and its market is growing fast (at least 20% - 30% per year). These two simple characteristics, set apart the business success stories, which make their backers tens of millions of pounds, from the run-of-the-mill businesses that just about breakeven but never make anyone rich.

• If you are founding a business, look for a gap in the market where you will be number one from the beginning. And look for a niche big enough that you can sustain rapid growth for many years. Once you establish a leadership position, do everything you can to retain it. More importantly, if you fail to get a leadership position, or you find your niche is not as big as you thought, it is better to cut your losses and direct your efforts elsewhere.

• If you are an investor, look for embryonic star businesses that you can back, where you can have an active say in their management (and ensure they remain stars).

• If you lack the resources to found or invest in a business, try your utmost to find a star business and go to work for them – the ‘first 20 people’ in on the ground floor can reap the benefits later on by getting shares or options. What’s more, working for a star business is much more fun and a much better learning experience than working for big corporates.

Koch exhorts every reader to try one of these three: found, invest in or work for a star business.

“Between 95% and 99% of businesses are not stars. For every 20 ideas you have, you can confidently junk 19 of them, because they won’t be ideas for a star venture. This saves an awful lot of money, sweat, toil and tears. Star ventures are rare...but they contribute over 95% of long-term value and probably at least 120% of the cash ever generated.”

Now every ‘recipe book for success’ needs to be read from a critical perspective (with ‘a pinch of salt’ if you will). Most importantly, if someone has found a foolproof method to ‘get rich quick’, you would reasonably expect them to spend their time executing their method, not writing about it. Well Richard Koch has already proved his entrepreneurial and investment credentials. As he describes in the book, it was his experiences with a diverse range of start-up businesses that allowed him to refine his idea of a ‘star business.’ He has been involved in five successful start-ups and made over £100m. “Koch is someone worth listening too,” wrote the Independent; this book is worth a read, as soon as you get the chance.