One of the greatest lessons I have ever learned about finances and business is the ability to accept sunk costs.
The second lesson in finance, which was game-changing for me, was the ability to understand marginal costs.
In this little financial blog, I would like to explain the significance of both in the hope that it will benefit someone else who reads this in the way that it benefited me.
1) Dealing with sunk costs is an emotional, ego-driven exercise.
In essence, it centres around the principle of cognitive dissonance, where someone gets so far into something that they feel that if they pull themselves out of it, they will look idiotic.
Tons and tons of work has been done on this, but most notably described by Malcolm Gladwell in David and Goliath.
If you want to understand cognitive dissonance and sunk costs, think of someone at the casino on a losing streak continuing to throw money after money after money and losing more.
That's how the principle of sunk costs works.
You start a project and invest in it; you imagine that it will go off on a trajectory which will make you a billionaire, will improve life for your patients or your team or be something super successful because that's how it existed in your universe. Slightly further down the line, you understand that that hasn't happened, and then you realise it's time to stop. Getting over the fact that you've already invested something in that, but that it's not worth investing more in, is a sunk cost.
Sunk costs come in many different guises in business; maybe a member of staff who you thought was great, to begin with, whom you invested such a lot of time in is not what you thought they were; maybe it's time to cut your losses and to go your separate ways.
However, you look at that there will be a cost, a recruitment cost, a lack of knowledge, a training cost, a reintegration cost, an emotional cost to the team when they see someone else going, all of that is a sunk cost which you have to be prepared to accept to get to a better place.
No business ever moves forward with a 100% record on investment or spending. Obviously, going in the opposite direction and going too far into costs, which ruin the business for no return, is a bad thing, but understanding some costs is an essential aspect of the business.
2) Marginal cost
Marginal cost fascinates me. Here is the story of how I learned about marginal cost as a boy. I remember learning it and understanding it.
I was working at Tesco, and I was given a tour around the new shop that we were moving to, which was all singing, all dancing, and all digital (Or as far as digital could be back in 1992).
One of the areas we went to was the Tesco Shoppers restaurant, where the person who was giving us a tour demonstrated the Coca-Cola machine.
This was the machine where you took the paper cup about half a litre in size, put some ice in, and pressed it against the lever, Coca-Cola came out, and you put a lid on in a straw and you gave it to the customer.
The guy giving us a tour explained to us that after the machine was installed, it cost Tesco 6p. Cup, ice, drink, lid, straw – 6p.
The customer was paying 99p at that stage.
There was obviously a charge for being there for the staff, for the heating, for the rent but the product cost 6p.
To refill the cup for the customer costs almost zero. That is a marginal cost.
Fast forward 30 years, and go to the cinema. There are these fancy machines with a million different Coca-Cola flavours. It is £5 for a big cup (I'm going to the cinema tonight). You cannot fill that cup up enough for them not to make any money; you can never drink enough Coke for the marginal cost principle to disappear.
Examine marginal cost, find out where it is in your business and use it as best you can.