Question

Before you go into your boss’s office (the COO) for a meeting, you hear him berating the CFO about a local building project your company is currently pursuing.

CFO: “But, Todd, according to the latest projections from the university next year, they anticipate a 22 percent decrease in enrollment. These are the very students we were targeting this complex for. This could result in an estimated loss of revenues of nearly 30 percent!”

COO: “Alex, I’m sick of this discussion. According to your numbers, we’ve already spent $200,000 on the foundation and pipe laying for the utilities to that apartment complex. You’re wanting us to abandon all the money we’ve spent on this project?”  

For the meeting, you are holding in your hand the projections you’ve just finished in order to give to the two officers in the C-suite. It shows the following:

                        Estimated population growth of community over the next 5 years = -1.4 percent

                        Estimated revenues from decreased enrollment projections = $77,000

                        Estimated variable costs from operating complex when opened = $90,000

                        Analysis of community trends: small-town atmosphere, mostly retired homeowners; not expecting growth in middle-class due to COVID-19 effects; college population decreasing

                        Confidence in above estimates= 88 percent

Upon going into the office, the two men look at you quizzically. The COO looks at you and asks your advice. What do you tell him?

Answer 1

Since there is a probability of Operating losses, it will not be prudent to continue operation. There is a popular concept known as Sunk Cost fallacy. The initial investment done is a sunk cost. That cannot be recovered. However, standing today, if we continue operations, it means that there will be further losses. The cost to operate is higher than the expected revenue. So with time, the losses will keep on piling. It is better to cut losses at this stage and abandon the project. In that way, the loss will be limited to the initial investment only.

So the advice to the COO would be to stop the project and ensure that the losses do not pile up and they are restricted only to the losses already made. If possible, that partly finished project can be sold to some other party to recover some part of the cost, but it is not at all wise to continue operations.

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