Thursday, September 13, 2012

"Affordable loss" concept helps reduce the cost of failure

Affordable loss is a concept defined by Prof. Saras Sarasvathy of the University of Virginia's Darden School. The website effectuation.org provides a very concise definition of the concept:

Affordable loss involves decision makers estimating what they might be able to put at risk and determining what they are willing to lose in order to follow a course of action. Using the entrepreneur’s new venture plunge decision, this article combines insights from behavioral economics to develop a detailed analysis of the affordable loss heuristic. Speci´Čücally, we develop propositions to explain how individuals: (1) decide what they can afford to lose; and (2) what they are willing to lose in order to plunge into entrepreneurship.

This video from Professor Stuart Read of the IMD business school elaborates on the idea of affordable loss. Rather than sketch out a long-term vision and quantify potential, competitive strategy and define target customers, launching with affordable loss is done by defining a crucial first step (or steps) and deciding to invest a fixed amount (money and time) in it. If that step achieves its goal, it would justify more investment and the next step can be taken.

Affordable loss helps an entrepreneur know when something is not working and gives a signal that an effort should be stopped or redirected before too much money and time is spent. It's also discussed in two recent business books, Peter Sims' "Little Bets: How Breakthrough Ideas Emerge from Small Discoveries," and "Just Start: Take Action, Embrace Uncertainty, Create the Future," by Leonard Schlesinger et al.

Here's a quote from an entrepreneur who is interviewed in the video, Kevin DeWhitt, founder of Agilyx, a maker of alternative fuels:

The primary key was a wife who understood me. And when I came to her and said, "Honey, I think in a year's time if I develop a model and a story, I think I can get this project funded, and from there we can move on our way." In reality it took 2 years, and that was 2 years of a scientist not generating any income. There were 5 kids in the house, and a wife that was supporting everybody, that's a little hard. That vision, though, that she and I had together and she allowed me to pursue was really key in getting it launched.

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