Building on sunk assets outsmart your legacy solutions

I don’t know that much about economics, but I do have (a bit of) common sense. In a Harvard Business School article, Clayton Christensen writes about “How Will You Measure Your Life?” It ends with a bit of religion inspired thinking (to which I, even as an atheist, can somewhat relate to (stay true to your principles)), but let’s not focus on that. The start of the story is on how to think of investments, and how different thinking about investing is between start-ups (with few assets) and established companies. He takes Blockbuster as an example (an old-style video-rental store in the USA):

Blockbuster’s mistake? To follow a principle that is taught in every fundamental course in finance and economics. That is, in evaluating alternative investments, we should ignore sunk and fixed costs, and instead base decisions on the marginal costs (any additional costs required to produce the next unit, ed. (src: wikipedia)) and revenues that each alternative entails. But it’s a dangerous way of thinking. Almost always, such analysis shows that the marginal costs are lower, and marginal profits are higher, than the full cost.

(before I continue to the Dutch audience: Nederlanse lezers willen dit artikel misschien lezen via Google Translate of Microsoft Translate)

I’ve never been to business school. The only thing I learned about sunk costs is that you should be aware of sunk costs when it comes to thinking about where to throw your money at: you shouldn’t waste your resources on anything that will just make you lose more: don’t throw money after bad.

Following this reasoning some people might have started to think that you should always ignore sunk costs, that sunk costs don’t even exist. Maybe to prevent you from throwing money after bad. The problem, however, is that the sunk costs have often brought you something or somewhere: a working product, a house, something useful, maybe even a business model that has worked for you. It may not be perfect, but still, it’s better than nothing, right?

So you have an asset. Built something valuable. And with a few additional investments it could be even better. Well…

If you totally ignore the fact that you’ve spent millions already and just focus on the extra costs, you might get trapped in thinking that investing in something new is much more expensive than improving on what has been built. It’s hard to tear down something you’ve made, and rebuild something new from scratch¹. The trap of this kind of reasoning is exactly what leads you to actually throwing money after bad. That’s why we should be very aware of sunk costs, and the size of it. Only then we’re able to make estimations on how profitable our undertaking can actually be, and, moreover, make estimations on how profitable an competitive undertaking can be.

One should always consider the alternative approaches that allow you, or your competitor(!), to outsmart your legacy solutions with far less resources. That’s what made Netflix beat Blockbuster. Your challengers will search for ways to outsmart your way of building and delivering by starting from scratch, and in the meanwhile you’re paying interest for not having tried to outsmart yourself.

The hat-tip is to 37 signals who highlighted the quote in the article by Clayton Christensen by Henry Ford: “If you need a machine and don’t buy it, then you will ultimately find that you have paid for it and don’t have it.” You might also consider this as an alternative take on ‘someone is coming to eat you’ that recently appeared on randsinrepose (Michael Lopp).

¹ This is purely economical thinking: as a bit of a greeny myself I would also urge you to consider environmental impact as well, especially when talking about physical structures (e.g. houses)