Letting Go Is Always Tough: Companies and Exit Decisions
Imagine this: 20 minutes into a movie with big name stars, you realize that it should probably rank in the 5 worst movies ever made. Will you leave – if the ticket cost you $10?
- What if the movie ticket cost you $60 and 3 hours of waiting in line?
- What if this were a concert and you paid $450 and waited 3 months? Will you get up and leave 20 minutes into it or keep waiting for another 15 minutes, another 30 minutes, another 45 minutes – hoping, perhaps praying that it gets better, because you paid $450 after all and its going to kill you if you “threw it all away?”
Welcome to the world of cognitive biases.
The scenarios listed above are examples of the sunk-cost fallacy or bias, one of the four, that a McKinsey Quarterly article argues prevents companies from getting out when they should – out of unprofitable divisions, businesses or even industries.
The other biases cited in the article are equally pernicious and can waste money and destroy value:
- Confirmation bias: A company or an exec believes something and by god, they will find evidence to support their beliefs – literally blinding them to any contrary evidence.
Could some of this have happened at GM with its Volt electric car? Surely they knew that demand for it would be far below what was needed to drive down costs with massive economies of scale?
- (Revisiting the) Sunk-cost Fallacy or bias: Throwing good money after bad because so much money has already been sunk into a new product or division and shutting it down means that the investments to-date are “lost”.
- Escalation of Commitment bias: Related to the sunk-cost fallacy, this is where a group of otherwise level-headed execs or CEO decides that since $X has already been spent and failure seems to be guaranteed, they will spend another $Y and then another $Y hoping against hope that $X + $Y + $Z will somehow turn things around.
The example from the article illustrating both these biases:
The Vancouver Expo 86 is a classic example. The initial budget, CAN $78 million in 1978, ballooned to CAN $1.5 billion by 1985, with a deficit of more than CAN $300 million. During those seven years, the expo received several cash infusions because of the provincial government’s commitment to the project. Outrageous attendance estimates were used to justify the added expense (the confirmation bias at play). Predictions of 12.5 million visitors, which would have stressed Vancouver’s infrastructure, grew at one point to 28 million—roughly Canada’s population at the time. Moreover, Canadians had seen budget deficits for big events before: the 1967 Montreal Exposition lost CAN $285 million—six times early estimates—and the 1976 Montreal Olympics lost more than CAN $1 billion, though no deficit had been expected.
- Finally, the Anchoring and Adjustment bias - relevant to divestment decisions where once a group or division is valued at, say, $100m, as evidence mounts that the value is declining, the blinders come on and every subsequent lower valuation is discarded for being too low. The article’ss example is illustrative of the major erosion in value because of this bias:
The sale of PointCast, which in the 1990s was one of the earliest providers of personalized news and information over the Internet, shows this bias at work. The company had 1.5 million users and $5 million in annual advertising revenue when Rupert Murdoch’s News Corporation (NewsCorp) offered $450 million to acquire it. The deal was never finalized, however, and shortly thereafter problems arose. Customers complained of slow service and began defecting to Yahoo! and other rivals. In the next two years, a number of companies considered buying PointCast, but the offer prices kept dropping. In the end, it was sold to Infogate for $7 million.
The full, long article talks in more detail about these biases and how to overcome them, along with other examples.
So true! In our day-to-day life too, we do many such things.