The effect on sunk costs and opportunity costs on a subjective capital allocation decision

The allocation of organizational resources is one of the most important decisions confronted by management. Previous research has indicated that irrelevant sunk cost or failure to provide explicit information regarding opportunity cost can lead to management making sub-optimal resource allocation decisions (Arkes & Blumer, 1985; Garland, 1990; Garland & Newport, 1991; Hoskin, 1983; Northcraft & Neale, 1986; Simonson & Nye, 1992). Sunk costs are any costs that have been incurred in the past. Thus, a sunk cost cannot be changed by any current or future action and is, therefore, irrelevant in decision making. An opportunity cost is the potential benefit given up when selecting one course of action precludes selecting a different action. Although decision makers tend to overlook or underestimate the importance of opportunity costs, they are just as relevant as out-of-pocket costs when evaluating decision alternatives.

Research related to the allocation of resources has reported that managers frequently make decisions to escalate commitment to ongoing projects. This escalation effect is present even when economic conditions suggest that canceling the project would be the best alternative (Staw, 1976, 1981; Staw & Ross, 1978). Schaubroeck & Davis (1994) and Whyte (1986) suggest that prospect theory provides an explanation for the escalation phenomena reported in this earlier research. Prospect theory is a descriptive model of decision making that attempts to explain violations of traditional normative models of decision making that are based on economic theory. The value function of prospect theory is convex for losses and concave for gains. This implies that the decision maker values losses differently from gains. Gains are overvalued and losses are typically undervalued (Kahneman & Tversky, 1984). Prospect theory proposes that decision makers behave in a risk-seeking manner when a situation is perceived (framed) as a loss, while risk-averse behavior is observed when a situation is perceived as a gain. Thus, escalating a commitment to a losing proposition (risk-seeking) may be explained by prospect theory if the decision maker undervalues the probability of a loss occurring.

The primary purpose of the current study is to investigate the effect of historical or sunk cost information on the allocation of organizational resources, within a prospect theory framework. A case methodology is used to accomplish this purpose. This study extends previous research by...