October 2011

Emotional involvement can cause management to exhibit more risk-taking behavior on projects that should be discontinued.

Lawrence Metzger, PHD, CPA, CMA, CFM
Professor of Accounting
Loyola University Chicago

The capital budgeting process is an integral part of any company’s long-term decision-making. Capital projects normally take several years from inception to completion, and problems can occur over time that may even bring into question the initial decision to proceed with the project. Examples include cost-projection overruns, time overruns, technology not living up to its intended use, competitors making moves that render the chosen option obsolete, better technology or products becoming available even as the updated or new system is being installed, and poor original cost and benefit estimates. Any one or combination of these factors can leave an organization and its decision makers wondering whether it is appropriate to continue with the option chosen, even after significant time and money have been invested.

A critical but often overlooked part of the capital budgeting process occurs during the years following initial approval of a project. This ongoing process of feedback and control, sometimes referred to as a post-implementation audit, represents a continuous appraisal of the project as it moves along and provides information for determining whether the project should be continued, revised, or terminated. It is part of any risk management program undertaken by the company in general and the internal audit department in particular. The development of new drugs, the installation of a new IT system, or the upgrading of manufacturing technology are all examples of expensive long-term projects that require monitoring as they proceed.

As part of a post-implementation audit, internal auditors must be keenly aware of emotional issues that commonly occur as expensive projects move along, especially if they are not proceeding according to plan. Emotion can result from conduct commonly referred to as escalation behavior and can have a serious effect on how managers make decisions regarding the future of any long-term project. The independence and objectivity that internal auditors can contribute to the analysis is crucial in helping management make appropriate decisions.

THE INFLUENCE OF SUNKEN COSTS

Most decision makers would agree that the money already spent on a long-term capital project is sunk and therefore not relevant to a decision to continue or abandon the project. But decision makers have difficulty applying this concept because individuals are prone to a particular bias in sequential decisions — namely, a tendency to escalate commitments. Specifically, more resources are allocated to an ongoing project — a sunk cost — despite information suggesting that the project may not produce its intended outcome. In other words, managers continue to throw money at the project as a way to recover what may have been an initially bad decision.

Many reasons have been put forward to account for the strong influence of sunk costs on decision-maker behavior. No one wants to appear wasteful or admit to making a mistake. Another explanation revolves around risk behavior. Individuals tend to be risk averse when a situation is framed or perceived as a gain or win situation but will exhibit more risk-taking behavior when a situation is perceived as a loss or losing situation. In the case of a long-term project that has run into problems, a manager, especially if he or she was involved in the original decision, may be more prone to take risks knowing that an abandoned project will be perceived as a loss. In a sense, hope replaces logic in the decision process. Also, in a sunk cost situation there may be an inflated estimate of the likelihood that the completed project will be a success. The decision makers carry on despite desperate odds because they do not perceive the situation as a lost cause.

Next, people will expend substantial amounts of time and money to achieve a receding or elusive goal. Slowly souring ventures are much more likely to show escalation tendencies. Sunk costs may influence project decisions when they are linked to the perception of progress on a course of action (i.e., the more that has been spent, the closer the project is to being a success). This action makes sunk costs appear relevant in a decision when in fact they never are. This is a common occurrence with gamblers who feel the next bet will be the one that pays off. A manager may feel that just a little more time or a small additional investment will be all it takes for the project to be successful, when in fact it might never actually work. Whenever a sunk cost dilemma involves the choice of a certain loss (abandon the project) versus a long shot (maybe it will be profitable years from now), a “certainty” effect magnifies the loss and encourages the decision maker to take the long shot.

Also, the larger the cost of the project, the more likely the decision maker will stick with the venture until its completion, regardless of evidence that it may fail. The argument here is that the additional cost of completing the project is less than the expected revenue earned from the completed project, which is by no means certain. And of course, the larger the initial expenditure, the more wasteful it will appear to stop the project.

Lastly, managers sometimes feel trapped into making a specific decision. This often has to do with psychological costs. Decision makers in entrapment situations typically incur continuous losses as they seek or wait for an eventual goal.

SUNK COSTS AND ESCALATION

The effect of sunk costs can lead to escalation behavior. Escalation situations can be defined as those where losses have been suffered, there is an opportunity to persist or withdraw, and the consequences of these actions are uncertain. In these cases there is a tendency to let costs already incurred (sunk costs) have an impact on the decision to continue, despite evidence to the contrary.

Why does escalation behavior exist and why can it be so influential in a decision maker’s thought process? One explanation is that behavioral and emotional forces match or exceed the strength of any negative economic data to hold organizations and their decision makers in a losing course of action. Behavior is often influenced by several, sometimes competing, forces. Individual decisions to escalate are rarely exercised in isolation — choices are often influenced by social and organizational forces surrounding the decision maker. Causes of these behavioral forces can be classified into three categories: project forces, individual forces, and organizational forces.

A capital project can take on a life of its own. For example, there may be uncertainty as to whether the setback is temporary or permanent. If deemed temporary, there may be more reluctance to withdraw. But this may be an optimistic point of view. Next, the expected level of future expenditures or costs necessary to complete the project may cause escalation behavior. If the estimated future costs seem small relative to the total cost of the project, it might be viewed as money well spent. But these cost estimates might be unrealistically low to provide “evidence” that the project is close to completion. Also, if there is a perception of no readily feasible alternatives, then continuing to spend money regardless of the current and projected situation may seem the only course of action.

A decision maker’s need for self-justification for a project performing below expectations is one cause of escalation behavior. Sometimes people do not want to admit that they made a mistake. Those who made the original decision to proceed with the project may be selective in their assessment of the potential success of the project and acknowledge only the information that supports their initial choice. When any loss from an initial investment systematically distorts the judgment of the decision maker, he or she may continue toward a previously selected course of action.

Oftentimes managers are motivated to manipulate others’ perceptions of their performance. Within the context of escalation behavior, this would imply continuing with a course of action that is nonoptimal for the company but optimal for the manager. This behavior pattern is in accordance with a manager’s desire to establish a reputation. Discontinuing a failed project could thwart this goal and hurt future job opportunities. To avoid being perceived as weak-minded, vacillating, or undependable, the manager will ignore pressure to reconsider his or her decision and stick firmly with the chosen alternative, even after the individual has started to suspect that it is a defective choice. From the manager’s point of view, the escalation of commitment can be seen as a rational act.

Escalation behavior also can be influenced negatively by organizational factors, primarily with respect to management’s expectations and the formal decision-making process. There may be high-level political support for the project within the organization that makes it difficult to stop even if the evidence says to do so. There also may be outside influences from stakeholders who might consider stopping to be a waste of money. Of course management is aware of, and susceptible to, these pressures and may have its decision focus compromised.

MANAGEMENT’S ROLE

Reducing the need for managers to become defensive and protective of their decision to invest in the project goes a long way toward reducing escalation behavior. Management should have in place an appropriate and formal process for evaluating and selecting potential capital projects. Sometimes projects do not turn out as planned, and management should recognize this as part of business risk. As long as the manager carefully and fully followed the process set up by management, he or she should not feel the need to justify a losing course of action by enhancing the commitment.

Decreasing the need for external or self-justification also may reduce escalation behavior. This can be done via the performance evaluation. Managing and making decisions are inherently risky and, on occasion, failure occurs. Reducing the need for justification may allow managers to withdraw from a failing project without psychological costs.

Promotion criteria and compensation packages should be disconnected from the success or failure of an appropriately evaluated and approved decision. This realization will allow decision makers to act rationally on behalf of the organization rather than themselves. Although the decision may have been costly to the organization, this is the normal course of business.

Does organizational escalation behavior constitute a tone at the top/corporate governance issue? Decision makers must trust that upper management will back their decision as long as the appropriate process was followed. Managers should feel comfortable asking for help on decisions, and job status should never be held over a manager’s head. More specifically, management can help deter escalation behavior by:

• Creating formal polices and training for developing a capital project initiative, including requiring the information not just for approval but also requiring measurement parameters over the course of the project, including potential abandonment costs.
• Having multiple layers of review to ensure that no one takes sole responsibility for a project that was approved by senior management and did not meet expectations.
• Recognizing that long-term decision-making involves risks, and rather than assessing blame for projects gone bad, considering them learning tools to make better choices in the future.
• Not becoming politically attached to a project, especially a costly one, as this might force the company into ongoing escalation behavior.

Management is ultimately responsible for what happens within the organization. By having suitable policies and procedures in place, and setting the right tone for behavior, management can reduce escalation behavior, and its consequences can be minimized.

THE INTERNAL AUDITOR’S ROLE

The internal auditor’s responsibility for the detection and prevention of escalation behavior falls under the standards of risk management and control. Management must set in place policies and procedures that help ensure that escalation behavior is avoided. There are inherent risks when procedures are not followed — specifically, the costs incurred from allowing escalation to occur. The internal auditor must be aware of policies and procedures and develop audit processes that help ensure that managers who are making capital project decisions are complying with management’s expectations.

Interwoven with risk assessment is the internal auditor’s responsibility to help organizations maintain effective control over operations and decisions. Auditors should assist in developing financial and operational information to help evaluate the viability of a long-term project and avoid escalation issues. Preventing escalation behavior is one element of safeguarding assets — namely, protecting future cash outlays on a project that will not bring future benefits.

Also, although escalation behavior may not fall under the formal definition of fraud, as it is less an intent to deceive and more of an unrealistic interpretation of the facts at hand, there is an issue of the integrity of the information and the decision made. It is the responsibility of the internal auditor to maintain the integrity of the reporting system and the decision-making process.

The best way to prevent project escalation behavior is to provide the most relevant information for the evaluation of the project over its entire life cycle. Research shows that escalation behavior is greatly reduced when clear-cut financial data are available to the decision maker — making it clear that persistence is more costly than withdrawal. Specifically:

• Before the long-term project is formally begun, internal auditors may help assess how reasonable the projected future cash-flow estimates and assumptions are for evaluating the long-term profitability of the project. The more accurate and reasonable the initial estimates, the less likely the project will show negative results that may increase escalation behavior.
• Along with the measurement of the costs at the adoption of the project, there should be clearly defined parameters to measure progress — a process that requires regular assessment of the costs and benefits provided — with a focus on future costs and benefits. There should be no emphasis on resources already committed, as those are sunk and irrelevant to any future decision.
• There should be ongoing estimates of project abandonment costs that focus on the current or future costs to accomplish shut down, not what was originally spent on the project up to the abandonment date.
• Along with project cost/benefits values, the organization should look for better alternatives continuously, even after the initial choice has been made. This will help prevent the decision to forge ahead because managers responsible for making escalation decisions feel there are no better options.

As part of both the risk and control functions, internal auditors assess the risk associated with escalation behavior and render an opinion on the reliability and effectiveness of the information and decision process required to make escalation choices.

A LOSING CAUSE

The decision to escalate a commitment to a losing position is a risk inherent in long-term capital investment. Along with the incurrence of additional costs that oftentimes do not pay off, the organization also incurs opportunity costs (i.e., opportunities lost by continuing to invest resources in a losing cause). It is the internal auditor’s responsibility to make management aware of the risk of escalation behavior and to advise how to guard against it. By implementing policies and procedures to help deter unwarranted escalating commitments, the organization can remove negative emotion involved in decision- making and proceed more confidently with long-run decisions.

 

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Abandon Ship
Very good article. One question, how do you marry up conflicting policies of wanting to reduce escalation risk with HR policies of tying incentives and other enhancements to successful performance, ie projects and work? Thanx, D
Posted By: Doug Green
2011-11-03 9:12 AM

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