By Daphne Main and Robert G. Rambo
Organizations often have multiphase projects involving serial decisions, such as R&D projects, joint ventures, or new product launches. For example, R&D projects require fairly extensive planning as well as reassessment of direction. The decision to continue with the R&D project may be re-assessed a number of times before a product/process is finally developed and put into production. Once the project is underway, the decision to continue may need to be reassessed periodically to judge the effectiveness and benefits of the project.
The primary problem in making a series of decisions is knowing when a continuing investment of time, money, or other resources is justified. Due to the ambiguous nature of future cost/revenue projections and of feedback from past decisions, companies may continue a project even when its prospects appear dismal. This is the result of a decision-making phenomenon known as "entrapment." Entrapment can occur whenever decision-makers maintain hope that projected positive outcomes will materialize despite current and projected assessments that a project appears to be failing.
Social psychologists have examined serial decisions by manipulating different potential influences on decisions and describing how people respond. As analyzed in a work by B. Staw, these influential factors include project, psychological, social, and organizational characteristics, as well as temporal aspects of the current decision within the series of decisions. Based on research, one recommendation to reduce entrapment consists of increasing decision-makers' awareness that entrapment can occur.
Most of the characteristics inherent in a project that can lead to entrapment relate to the financial aspects or economics of the project. Common problems leading to entrapment are also inherent in many financial decisions: ambiguity about outcomes, exposure to opportunity costs, salvage or closing costs, the size of the investment left to finish the project, the size of the expected return on the investment, and so forth. However, certain combinations of these factors can virtually assure entrapment: for example, large up-front costs with no return until the end of the project coupled with substantial closing costs (as with many construction and R&D projects). A classic example of this situation is Long Island Lighting Company's decision to continue with the Shoreham Nuclear Power Plant. The plant was originally projected to cost $70 million, but with cost overruns, regulatory delays, and public loss of confidence in nuclear power, the plant ended up costing more than $5 billion. The company stuck with the construction for nearly 20 years, before selling the plant to the State of New York for $1.00. Although LILCO never would have proposed building a $5 billion plant, the executives apparently felt trapped into continuing with construction because stopping the project would have meant nearly certain bankruptcy.
As indicated in the exhibit, early on in the life of a project, project characteristics are the overriding concern in decision making. Managers tend to emphasize the economics of the project in deciding whether to continue or drop the project. There is less chance that entrapment will occur at this stage. Later, as investment mounts, psychological and social factors will begin to dominate decision making and lead to entrapment in a failing project. As the project begins to take on a life of its own, organizational factors may additionally increase the likelihood of entrapment.
There are four common psychological reasons that underlie entrapment: over-optimism/illusion of control, self-justification, framing, and sunk costs.
Overoptimism/Illusion of Control. All too often, organizations uncritically assume their cost-benefit projections are realistic, leading to inflated expectations for a project. However, research has shown that people are too optimistic: They consistently overestimate revenues and underestimate costs. Further, managers think they can control what happens to them. Obviously, these tendencies will influence the information selected for consideration before a decision is made. An example is Harrah's decision to build a land-based casino in New Orleans. The revenue projections were overoptimistically set at $400 million annually. The actual revenues were at best no more than $1 million per month of the six months of operations before Harrah's filed for bankruptcy.
Self-Justification. Individuals responsible for making a decision tend to commit more resources to a losing project to justify their initial investment decision. Further, individuals tend to search for evidence that suggests the project should be continued and disregard evidence to the contrary. An example of self-justification leading to entrapment can be found in banking. Problem loans are more likely to be given extensions or additional loans by officers responsible for the initial loan as compared to decisions made by officers not responsible for the initial loan. Similar results have also been identified for performance evaluations and recommendations for raises. Recommendations/evaluations made by supervisors responsible for hiring a problem employee are more likely to be higher as compared to
Framing. The perspective from which a decision is framed or perceived can lead to entrapment. People who perceive a decision as resulting in a positive outcome tend to not take a chance of "blowing it." People who perceive a decision as resulting in a negative outcome will often take a gamble to try to avoid the loss. Research indicates that managers making a restructuring decision tended to be more conservative in their decisions when the problem was described as "saving jobs." When a restructuring decision was described in terms of "losing jobs," managers were more likely to make risky decisions.
Sunk Costs frequently intrude into managerial decision making. The appeal of sunk costs may partly come from the need for self-justification if managers are arguing about not "wasting money already spent." However, research has determined that sunk costs tend to cause more entrapment when these irrevocable expenditures appear to be identified with the apparent achievement of the project goal. People often believe they will save money or avoid losses by considering sunk costs. Apparently, there is widespread misperception of the relationship between spending money (and other resources) and the desired outcome.
The social need to justify decisions to others also plays a role in entrapment. Admission of a mistake can lead to loss of reputation and of career. The need to "save face" may become particularly urgent when managers have to end a project in front of a large "audience." Obviously, the perceived threat of job loss as a result of admitting to a poor decision will drive managers to commit additional resources. Thus, managers may continue a project to avoid others' perception that they have failed.
People who stick by their decisions are rewarded with social approval for their persistence. Research has shown that when projects fail, managers receive higher approval ratings when they were perceived to have "stuck to their guns" than did managers who tried different strategies to save a failing project.
Inertia within an organization can also produce or continue entrapment. As the size of an organization increases, impression management up the chain of authority may distort information received by top management. Further, the channels of communication may discourage withdrawal from a failing project.
Corporate identity may also be tightly linked with a failing segment. For example, PanAm sold off its profitable hotel chain, namesake building, and valuable Pacific routes to pay debts of the airline before filing for bankruptcy. If corporate identity had not been as closely associated with the airline segment, the company might have sold the ailing airline division and stayed solvent.
Politics both within and outside the organization also may impede withdrawal from entrapping situations, as can be seen with restructuring decisions. Affected executives may perceive a project to be a "sacred cow," and thus reject any attempts to change or eliminate it. Outsiders can affect attempts to escape entrapment. For example, with Shoreham, the U.S. Department of Energy and pronuclear organizations were instrumental in LILCO's decision to continue construction of the plant. On the other hand, government may step in and bail out sinking companies considered "too big to fail" (e.g., Chrysler or the
At the third phase of entrapment, economic factors have already severely deteriorated, usually just at the point when organizational factors kick in. It may take very material losses to overcome these factors resulting in entrapment. The Vietnam War is often used as an example of how very large losses apparently have to be incurred before disengagement can occur.
Researchers also have identified strategies with which decision-makers can avoid or reduce entrapment. These suggestions include: use active decision making, consider explicit alternatives, set limits up front, seek disconfirming evidence, reframe decisions, and, in the long-run, change organizational evaluations of decisions.
Use Active Decision Making. Protection from uncritical entrapment incurred by optimism or inertia can be achieved by taking a more rational and systematic approach to decision making. The organization should be alert to uncritical administrative enthusiasm, especially for so-called short-term projects. Management should play out several scenarios for possible changes in economic, regulatory, or agency conditions by identifying probable costs that would be incurred if short-term goals take longer than expected to materialize; and by preparing cost-benefit analyses to determine if projected benefits would be worth the probable long-term commitment of resources and additional costs.
Consider Alternatives Explicitly. If uncontrollable factors, such as economic shocks or natural disasters, might have produced a poor outcome for a project, managers tend to escalate commitment to a decision. Because of the inherent difficulty in identifying the "real" reasons for failure (e.g., whether failure is due to unrealistic costs for the expected benefits or to bad luck), entrapment is more likely to occur. Management can work through scenario analysis for costs and revenues (best, worst, and average case versions) for projects to differentiate the relative contribution of bad luck versus poor planning. Identifying the relative contribution of bad luck can enable companies to make more rational decisions about continuing commitments.
Individuals and organizations also make many committing decisions merely through passivity, or by failing to act when there is an opportunity to do so. On a personal level, this may be exhibited by failing to change the allocation of retirement funds when the stock market changes or to obtain quotes from other insurance companies when the renewal notice is received. Entrapment also can occur with passive administrative renewals, such as with the automatic billing of services that require active decisions to stop services. The practice of automatically renewing project budgets falls into this category. Zero-based budgeting, which requires
Set Limits Up Front. Management should set a limit on the amount of resources to be invested before embarking on a project. Setting a limit prior to starting a project helps to provoke a more critical consideration of costs and benefits when committing additional resources. The limit also provides a rational and justifiable "escape route." This can be particularly effective when the limits are set "publicly" (such as to upper management), rather than privately. If the limit has been reached without attaining goals, the publicly announced limits permit management to reconsider their commitment or their strategies for realizing project goals. At this point, the value and expected benefits of further investment may be more critically reconsidered or discontinued.
Limit-setting strategies are illustrated by the popularity of feasibility or pilot studies, because the limited allocation of funds and time for such studies can provide managers with a "way out" if the project's benefits fail to materialize. However, two caveats about limit setting are necessary: (1) Studying a problem can become a self-perpetuating exercise
Seek Disconfirming Evidence. People have a tendency to seek evidence that confirms the "correctness" of their initial decision, rather than to seek evidence that might suggest otherwise. Tendencies toward entrapment can be critically examined if companies obtain another perspective on the decision from persons who are not responsible for the initial decision, within the organization or from outside. Many organizations have institutionalized use of a review panel or another manager to approve decisions. Separate departments in banks handle loan extensions or special repayment terms, thereby eliminating potentially costly face-saving attempts by the department making the initial loan decision. However, the "rubber stamping" of lower-level decisions (a symptom of organizational inertia) also should be avoided.
Reframe Decisions. Companies may need to reframe their decision to commit additional resources. As noted, cognitive psychologists have found that people who have already incurred a large loss will be more likely to spend additional money if they think there is even a slim possibility of ever recovering the funds already spent. Thus, as accounting texts suggest for sunk costs, clients should be advised to forget the money previously spent and refocus on whether any further expenditure of resources can be realistically justified for financial or other purposes. Management should emphasize future cost savings to direct attention away from the arguments that uncritically incorporate sunk costs (such as the common complaint that "so much has been spent, how can we throw this investment away?").
Public leaders, such as presidents, often are socially vilified for changing their minds about past commitments, even for failing policies. However, when changing a course of action is "framed" appropriately, a change of mind may not be held against the manager. For example, both Kennedy and Reagan were able to remove troops from the Bay of Pigs and Beirut, respectively---situations about which both presidents had said they were committed to keeping troops in place. By reframing their withdrawals as prudent in saving lives and money, these presidents were able to maintain public confidence. Thus, in self-defense, companies may need to be proactive to change others' perceptions of dropping a failing project by reframing their decisions as "saving resources," rather than as "losing resources." Framing effects are not merely semantic manipulations, but appear to be more like perceptual phenomena that direct attention to specific aspects of a problem.
Change Organizational Evaluation of Decisions. In some organizations, managers who are "consistent" (even if their consistency harms the organization) may receive better evaluations than do managers who "experiment" with different approaches. This creates a paradox: If a manager ignores previous commitments and chooses not to escalate commitment to a failing project, the organization is better off, but the manager may be perceived as being "wishy-washy" within the organization.
As mentioned earlier, often it is difficult to tell if a decision turned out badly because the decision was unwise or from external, random events, such as natural disasters or collapse of foreign stock markets. Managers would be less likely to become entrapped (due to face-saving and social perception factors) if their performance were judged on their decision process, rather than on the decision outcome. Management should institute reward systems that are based on the decision process, not just the decision outcome. For example, the decision process should be made more explicit, such as tracking how the decision alternatives were defined, which information was gathered to select among alternatives, how the decision process evolved (e.g., which scenarios and factors were considered), and whether feedback data that would confirm as well as disconfirm the decision's wisdom were collected. Giving managers the opportunity to use better decision strategies in evaluating continued investment in projects could guard against inappropriate continuation of projects. *
Daphne Main, PhD, CPA, and Robert G. Rambo, PhD, CPA, are assistant professors at the University of
Trapped in Failing Courses of Action
Entrapment is a decision-making phenomenon that leads organizations to continue a project even when its prospects appear dismal. LILCO's Shoreham nuclear plant is a prime example of entrapment. A number of factors leading to entrapment influence decision making as projects progress. In the early phase, the financial aspects or economics of the project dominate. As the project progresses, psychological and social issues come into play and eclipse the economic issues. Late in the process, organization issues (such as saving PanAm as an airline) become the dominant factor.
To avoid entrapment, decision makers should:
* Use active decision making
* Consider alternatives explicitly
* Set limits up front
* Seek disconfirming information
* Reframe decisions
* Change organizational evaluations of decisions.
When do you stop pouring money into a project?
©2009 The New York State Society of CPAs. Legal Notices
Visit the new cpajournal.com.