Sunk Costs, Commitment and Strategy

Münchener betriebswirtschaftliche Beiträge Munich Business Research 6XQN &RVWV &RPPLWPHQW DQG 6WUDWHJ\ Burkhard Pedell Ludwig-Maximilians-Universität München Fakultät für Betriebswirtschaft Burkhard Pedell∗ Sunk Costs, Commitment, and Strategy 2000-05 August 2000 ∗ Institut für Produktionswirtschaft und Controlling, Ludwig-Maximilians-Universität München, Ludwigstr. 28 RG/V, 80539 München, Tel.: +49 89 2180 3888, Fax: +49 89 34 40 54, e-mail: pedell@bwl.uni-muenchen.de Sunk Costs, Commitment, and Strategy Abstract Commitment is a necessary prerequisite for gaining sustainable competitive advantage. By the way of commitment a firm is able to establish mobility barriers for capital bound in specific assets and to protect thereby supernormal profits against competition by entry barriers. The main underlying mechanism creating commitment is the irreversibility of decisions. Irreversibility not only can give a sustainable competitive advantage but is also a necessary condition for the existence of risk. Even under uncertainty there is no risk if any decision can be completely and costlessly reversed at any time. In that case, strategy and planning for the future are not necessary at all. This reversibility condition is, of course, never completely fulfilled, alone taking into account the passing of time between two points of decision. Commitment is at the heart of competitive advantage and risk; both concepts are of outstanding importance for any firm. The aim of the paper is to analyse potential trade offs between the advantages and disadvantages of commitment and to give an overview of the factors that influence the optimal timing and extent of irreversible investment. The analysis is based upon the concept of sunk costs. Sunk costs measure the irreversibility of investment and constitute an important link between management accounting and strategy. Keywords: sunk costs, commitment, irreversible investment, competitive strategy, risk, real options JEL-Classification: L13, M40 1. Elements of Commitment In many industries specific and irreversible investment is of increasing significance. R&D investment in the chemical, pharmaceutical and bio-technological industry may serve as a vivid example. The building of networks, as in the telecommunications industry, asks for high specific investment. The market structure in most of these industries is neither a perfect market nor a monopoly but an oligopolistic market structure with strategic interaction. Therefore it is of crucial importance to understand the effects of commitment by irreversible investment on a firm and its competitors in these markets. The first step, necessary in order to analyze these effects is working out a precise definition of commitment. A commitment always consists of three elements (see fig. 1): commitment object of underlying force duration of commitment of commitment ... commitment ... makes breaking away from - period of time decision the decision / strategy ... resp. strategy - interdependence with subsequent ... impossible ... unfavourable decisions (real commitment) (economic commitment) elimination of change of the costs and alternative strategies benefits of the strategy or alternative strategies irreversible investment (measured by sunk costs) Fig. 1: Elements of commitment (1) An object to which the commitment refers: In a decision theoretic perspective this object is a decision or a strategy. (2) An underlying force of commitment: Commitment means that it is impossible or unfavourable to deviate from a planned course of action. Depending on whether it is literally impossible or just unfavorable as to the subjective goals of the decision maker to change the course of action we can differentiate between real commitment and economic commitment.1 The fact of being or not being commited economically to a certain strategy depends on if the costs or the benefits of breaking away from the strategy are higher.2 A real commitment is tantamount to an economic commitment with infinitely high costs of breaking away from a strategy. A real commitment eliminates alternative strategies whereas an economic commitment changes the cash flows of the strategy commited to or of the alternative strategies. A commitment to a certain strategy on one side can be established by implementing the strategy itself and by investing irreversibly resources or on the other side by accompanying actions that increase the costs or decrease the benefits of breaking away from the decision. Irreversibility of a decision means that the effects of 1 This differentiation already has been made by POTT (1991), pp. 13ff. 2 See also TIROLE (1988), p. 308. Sunk Costs, Commitment, and Strategy 1 the decision cannot be completely reversed. Empirically every decision is at least partially irreversible because the passing of time cannot be turned back. In section 2 it is shown how the degree of irreversibility of a decision can be measured by the sunkness of costs. (3) The duration of a commitment: The period of time a commitment persists in depends on how costs and benefits of breaking away from a strategy evolve over time. Two subcases can be differentiated: Either costs and benefits change with goals unchanged or the goals change themselves. In consequence the existence of commitment cannot be analyzed without knowing the individual goals of the decision maker. Furthermore commitment is only relevant if there are interdependences with subsequent decisions.3 A commitment changes either the alternatives of subsequent decisions or the costs and benefits attainable by those alternatives. The rest of the paper is organized as follows: In section 2 it is shown how sunk costs are derived in a decision theoretic perspective from past and potential payments of the firm. The degree of sunkness is related to the difference between the acquisition price and the liquidation price of assets the firm invests in for its competitive strategy. An overview of the causes for differences between the two prices is given. In addition the decision irrelevance of sunk costs is shown. The irrelevance of sunk costs leads to an asymmetry between the firm and its competitors. The firm enjoys a cost advantage for the irreversible investment and the corresponding competitive strategy. In section 3 a brief and systematic overview of the competitive advantages is given that can be attained by strategic commitment prior to product market competition in a duopoly game. It is demonstrated that sunk costs (not fixed costs) are the relevant measure for the shift of reaction curves by an irreversible investment. In accordance with the relevant literature distinctions are made between - product markets where the actions of the duopolists are strategic substitutes (falling reaction curves) and markets where the actions are strategic complements (rising reaction curves), - commitments that result in an aggressive reaction and commitments that result in a defensive reaction of the firm in the product market and - strategies to push the competitor out of the market as well as strategies to share the market. Alongside this, it is shown that the intensively discussed simultaneous attainability of cost advantages and differentiation advantages reaches support from the concept of commitment to specific resources. Section 4 contrasts the competitive advantages that can be gained by commitment to the potential loss of valuable flexibility. Based on the real options approach the conditions under which commitment means foregoing a valuable option to defer investment and the underlying value drivers are identified. Section 5 concludes with some implications for the management of investment and management accounting. 3 See GHEMAWAT (1991), p. XI; BESANKO/DRANOVE/SHANLEY (1996), p. 319. Sunk Costs, Commitment, and Strategy 2 2. Irrelevance of Sunk Costs Figure 2 illustrates how the concept of sunk costs can be derived from past and potential payments of a firm at two different moments of decision.4 t=0 is the moment immediately before the firm invests money in real assets, t=1 is any moment later at which the sunkness of the investment is measured. In t=0 the firm has disposal of resources in money. Here the firm can choose one of the two following decision alternatives. On one hand it can start a project and invest the cash outflow CO0 in real assets to get the expected cash flows of the project (CI = cash inflow; L = liquidation payment; D = time horizon) or on the ohter hand it can not invest and keep the money. For simplicity the discount factor is assumed to zero. In t=0 the firm decides to invest in real assets.