Sunk cost principle and DIPP criteria for project portfolio management

Among various concepts and principles for the management theory, “sunk cost” principle looks easy to learn, but is the most difficult to apply in practices. The sunk cost means the money we have already spent for a subject matter. Because it was already spent, our decision making should not be affected by it. The principle of sunk cost tells us to decide based on future prospectives of the matter. However, our way of thinking often reflects past history, and it is hard to make right decisions.

Let’s take an example. Suppose a woman bought ticket for a concert at ¥8,000 (roughly $70). It is a good price. However, she cannot find her ticket in her handbag when she arrives the concert theater. She might have lost it or just left it home. She confirms with the box office that seats are still available at the same price. She has money to buy it. The concert is held only that night. Then, what should she do? She should buy another ticket to enter, or just return home?

If she believes the concert is worth ¥8,000, then she should buy another ticket. She might have lost or forgot her original ticket. Whichever it was, the money she paid for the ticket never comes back. It is the “sunk cost”. The question is, now, simply to compare the concert value and price of ¥8,000, as seats are available and she can pay that amount. And for her, concert value would be greater (that’s why she bought one ticket before).

Nevertheless, people often wonder on this problem because they transform the question into “is this concert worth ¥16,000?”. This example problem was originally raised by the Nobel Prize Economist Daniel Kahneman (2012). He explains: “if the lady’s income this month is just ¥8,000 less that the normal month, then does she buy the ticket? Most people may answer “yes”. However, if the same problem is presented in a different fashion of “lost ticket she once bought”, then many reply wrong answer. This is because they put the lost ¥8,000 on the cost accounts. (Kahneman: “Thinking, Fast and Slow” chapter 34)

Similar problems arise during the course of much larger projects. I dare not mention its proper name, but a huge national dam construction project in northern part of Kanto region has been a political issue for several years. The underlying cause of this dispute is a fact that the central bureaucracy does not have any criteria or mechanism to terminate projects once they were commenced. One more complicating factor is a way of thinking “we’ve already spend so much amount of money, so we cannot stop the project to make it in vain”. Oh yeah, it’s natural to consider that way, unless we learn the principle of sunk cost. According to the economics, it is not relevant to our decisions no matter how much money has been spent. We have to make up our mind, just based on comparison between “amount of money to spend till the end" and “value of the dam when completed”.

It is very difficult to decide whether to continue or stop projects regardless of their sizes. Reality is that efforts and faces of project members are at stake.

“Amount of money to spend till the end” of a project is called cost ETC (estimate to complete) in the PM theory. “How many days till the end” is called time ETC. Cost ETC refers to the cost from now till completion regardless of the amount already spent. Total cost of a project when completed is called “cost EAC (Estimate at Completion)”.

Decisions about project commencement, continuation and termination are the problems in the project portfolio management domain. The most important factor is normally the economic evaluation, except for non-profit projects such as academic researches. There are various criteria for economic evaluation like NPV/IRR of DCF method, or payout period. However, there is a common limitation with them: they are all comparison between the total investment cost and the total profits. They are applicable for planning phase decisions, but not appropriate for judgement of ongoing projects because they do not take into account of the sunk cost principle.

In order to conquer these limitations, DIPP was proposed as a metric for portfolio management. DIPP stands for Devaux's Index of Project Performance, originally conceived by Mr. Stephen Devaux as well as DRAG and drag cost which I explained in previous articles.

Definition of DIPP is quite simple:
 DIPP = EMV / Cost ETC

Where, EMV represents Expected Monetary Value which is anticipated profits of the project. Its division by Cost ETC gives DIPP calculation. For example, suppose there are four projects ongoing. Some of them are in planning phase and some in execution phase, as shown in the below table.

e0058447_9415260.jpg


Very simple. Now, there comes another new proposal for Project E.

e0058447_942143.jpg


It seems to be a good idea to include Project E into our portfolio because it has higher profitability - unless it has any impacts to others. However, there is often a limitation of available man-power resources. Pursuit of Project E may affect other project schedule. If we have proper scheduling tools, we can evaluate it. The simulation result shows following impacts to the other projects.

e0058447_942311.jpg


Please be aware that EMV of each project decreases due to delay of the finish date. If we are too greedy and put priority to Project E, it will end up with depleted DIPP of the overall portfolio from 2.9 to 2.2. It may not be a good decision.

Of course, this is just a desktop calculation. We all know that other factors, such as gut feelings, prides or customer relations, etc. coming into the equation. However, it would bring out a significant difference for corporate performance in the long run, whether the management makes decisions with knowing this equation or without knowing it. Please also be aware that normal DCF method cannot evaluate such portfolio impact problems due to lacking of the sunk cost calculation.

DIPP increase as a project proceeds. This is because the Cost ETC, denominator of the equation, becomes smaller as the project reaches to its goal. When we have to prioritize budgets or resources among projects having different progresses or phases, it is rational to select the one which has the largest DIPP (normally the closest to the goal).

I have explained methods developed by Mr. S. Devaux in three article series. They were proposed in the US and have put in practices in military industries to some extent. I first learned them at the conference Project World in Boston in 2003. In that conference, many other new ideas or techniques were presented. I could feel enthusiasm by the people gathering in the PM field in the States.

12 years have passed since then. DRAG, DIPP or any other new idea has not been introduced to Japan. Discussions about PM in our country are still bound within PMBOK Guide(R) knowledge areas or just reports of in-house trial & errors. I believe we should have more sensible antenna for new evolution in PM theories in the world.




"Introduction to the basic of scheduling, and DRAG as the metrics for project delays" (2016-02-13)

"Drag Cost - The true cost that takes into account delivery schedule effects" (2016-03-20)
by Tomoichi_Sato | 2016-05-03 23:37 | English articles | Comments(0)
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