The principle of affordable loss
In a world characterised by constant change and uncertainty, traditional planning and decision-making processes often struggle to keep pace with the dynamics. This is where the concept of effectuation, developed by entrepreneur and researcher Saras D. Sarasvathy, comes into play. One of the central elements of effectuation is the principle of affordable loss. Instead of concentrating on maximising potential gains, this principle focuses on how much loss you can afford without suffering serious damage.
What is effectuation?
Abraham Lincoln is said to have once said: “The best way to predict the future is to create it.”
Effectuation follows this beautiful thought by supporting entrepreneurs to make decisions, especially in situations where the future is uncertain and they cannot control everything. Uncertainty arises when no one can predict exactly what will happen next.
The effectuation approach is a result of global entrepreneurship research led by Professor Saras D. Sarasvathy¹. It looks at the economics of start-ups in response to recognised market opportunities and at entrepreneurs who take a personal capital risk. In contrast to traditional causal approaches based on prediction and long-term planning, the approach focuses on creatively utilising the resources and means at one’s disposal to achieve goals and discover new opportunities.
The central principles of effectuation are²:
Means-orientation
Entrepreneurs start with the resources they already have – their skills, knowledge and networks – and consider what they can achieve with them. Instead of focussing on a fixed goal, they are open to various possibilities that arise from the resources available.
Utilising circumstances and coincidences aka the lemonade principle
“When life gives you lemons, make lemonade” is an English saying. Making the best of difficult and unexpected situations, i.e. producing sweet lemonade from sour lemons, describes a central attitude of companies that see unexpected events and uncertainties as opportunities. They are prepared to change their plans and adapt to new circumstances in order to find innovative solutions.
Partnerships
Entrepreneurs actively seek partnerships and co-operations. Partnerships allow companies to combine their own resources with those of their partners. This provides access to additional funding, expertise, networks and other important resources that they might not have on their own. Partnerships also help to spread the entrepreneurial risk; if several parties are involved in a project, each partner bears part of the risk, which reduces the financial burden for the individual entrepreneur.
Affordable loss
Instead of aiming for maximum profit, companies consider how much loss they can and want to afford. Let’s take a closer look at this principle.
How much loss can you afford?
In many areas, medium and long-term planning still makes sense. The construction of bridges, motorways or airports, the implementation of research projects in the pharmaceutical industry or the development of products in the aerospace industry often require years of preparation. And there are areas in which such planning no longer works because markets, market participants or consumer preferences change rapidly. This is where the principle of affordable loss can help to learn from experience and react flexibly to market changes.
The principle of affordable loss states that entrepreneurs and decision-makers should focus on how much loss they can afford without jeopardising their financial stability or operational flexibility. Instead of speculating on large but uncertain profits, the potential loss is calculated and controlled.
And how do companies determine how much loss they can afford? Companies determine how much loss they can afford based on a variety of factors that are highly dependent on their specific business context. These factors can vary depending on the size of the company, the industry it operates in, previous experience and the type of project they are pursuing. Here are some key considerations:
- Smaller companies may have limited financial resources and therefore a lower tolerance for losses compared to larger companies with deeper pockets. They may therefore be able to afford fewer losses before serious financial problems arise.
- For specific projects, the company might already have a predefined budget available for such purposes. This budget could be derived from previous experience, industry standards or strategic priorities.
- A company’s risk tolerance is strongly influenced by its corporate culture. Some companies are more willing to take higher risks to drive growth and innovation, while others prefer a more conservative approach and want to minimise losses.
- Current market conditions and the competitive environment can also influence a company’s decision-making. In a competitive market, companies may need to take more risks to differentiate themselves from the competition and gain market share.
And how much loss do you want to afford?
In practice, it can be observed time and again that the question “How much loss can you afford?” is supplemented by the question “How much loss do you want to afford?”. The first question relates primarily to the financial possibilities and the actual capacity of a company to absorb losses without getting into serious financial difficulties. The second question focusses on the conscious decision to take risks and thereby seize opportunities.
Of course, a company must know its current financial reserves and sources of liquidity in order to utilise leeway without jeopardising current business activities. In addition, the answer to the second question is determined, for example, by the company’s own aspirations or its position on the market:
- Companies that want to position themselves as innovation leaders may take higher risks in order to develop new technologies or explore new markets. This willingness can lead to a company deliberately taking higher financial risks to drive its innovation agenda.
- Companies that want to grow aggressively may be willing to take greater risks to enter new markets or develop innovative products. In such cases, management may be willing to accept temporary losses in order to capitalise on long-term growth opportunities.
In short, depending on strategic goals and the competitive environment, a company can decide how much financial leeway it can afford in order to strengthen or defend its position in the market. In any case, it is important for a company to make a balanced decision that takes into account its specific situation, objectives and long-term interests. A balance must be found between the financial possibilities and the strategic goals. The financial possibilities determine how much loss a company can practically bear, while the strategic goals determine how much loss the company is prepared to accept in order to achieve long-term goals or take advantage of growth opportunities.
Conclusion
The principle of affordable loss is based on the assumption that it is safe to take risks as long as the potential losses are controllable and bearable. This is in contrast to traditional approaches, where risks are often either completely avoided or only taken if high gains are expected. “How much loss can you afford” and “How much loss do you want to afford?” are two very useful questions that help to make decisions to take risks more consciously. They also promote a culture of experimentation and learning; companies can try out new ideas without fear of major losses. This lowers the barrier to entry for innovation and makes it possible to react quickly to market changes, which is particularly advantageous in dynamic and uncertain markets.
When did you first utilise the principle of affordable loss?
Extra bonus
Here you will find 3 additional questions about the principle of affordable loss answered by Michael Schenkel (please press the plus button):
Can the principle of affordable loss also be applied to roles or activities?
Michael Schenkel:
Yes, the principle not only applies to projects or developments, it can also be applied to roles and activities.
For example, is it worth employing a social media expert or do you need a feel-good manager? Often such questions cannot be answered clearly, as possible successes cannot be clearly assigned or quantified. The principle of focussing on a different aspect helps here: Are potential losses from employing a person or introducing a role acceptable? If the answer is yes, nothing stands in the way of employment.
Does the principle allow decisions made to be revised or adapted later?
Michael Schenkel: The principle of affordable loss allows decisions made with regard to the acceptance of losses to be revised or adjusted at a later date. This is because the principle is based on the assumption that losses are only accepted within a framework that is financially viable for the company. If circumstances change or new information becomes available, the company can reconsider its decisions and redefine the limits of affordable loss.
For example, at the beginning of a project, a company may decide to invest a certain amount in the development of a new product and accept this loss. However, if during the project it turns out that the market opportunities are better or worse than originally assumed, the company can adjust its decision by either investing more or stopping the project to avoid greater losses.
This flexibility is a key advantage of the principle of affordable loss, as it allows companies to react dynamically to changes and utilise their resources more efficiently.
Where can the principle of affordable loss be found in software development?
Michael Schenkel: There are various approaches and procedures that indirectly utilise the principle of affordable loss. What these approaches have in common is that they proceed iteratively, use continuous feedback and can therefore make adjustments to the procedure or development at any time or even make a different progress decision.
Here are a few examples:
Scrum is a framework for the development of software, products and services. It describes an incremental, iterative and empirical approach and defines the sprint as a central element. The sprint is a time-defined iteration of constant duration, with similar or even identical actions, and the goal of realising a defined solution. The risk of an erroneous development and thus a possible loss is limited by the sprint duration and the corresponding effort required.
The Minimum Viable Product – often abbreviated as MVP – is an instrument for minimising risk in the course of developing products, services or business models. An MVP is not about creating a product with few functions or benefits, but about finding out as much as possible about the product, the customers and/or the business model with minimum effort. The challenge is to define the “minimum” in such a way that the product is already usable, i.e. “viable”, and thus provides an initial benefit for customers. Customer feedback is essential for further development, because without it, companies run the risk of developing products based solely on assumptions and thus missing the target market.
Pretotyping is a method of testing product ideas as quickly and cost-effectively as possible. The aim is to find out whether a product would be bought and used if it existed. Using an extremely simplified version of a product, features and functions are simulated and the interaction of potential customers is observed in order to find out whether users would be interested in the product, would use the product in the way it was intended, would use the product regularly and would purchase the product.
[1] Saras D. Sarasvathy: What makes entrepreneurs entrepreneurial?
[2] In the literature on effectuation, sometimes four and sometimes five principles are described. The difference lies in the consideration of the “pilot-in-the-plane” principle. This principle is often regarded as a meta-principle because it summarises the other principles and gives them an overarching guideline. Companies believe that they can shape the future through their own actions and decisions. They focus on what they can control rather than relying on external circumstances and predictions.
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Michael Schenkel has published more posts on the t2informatik Blog, including:
Software development made easy
Impulses for organisations – Part 9
Are you already a project ambassador?
Michael Schenkel
Head of Marketing, t2informatik GmbH
Michael Schenkel has a heart for marketing - so it is fitting that he is responsible for marketing at t2informatik. He likes to blog, likes a change of perspective and tries to offer useful information - e.g. here in the blog - at a time when there is a lot of talk about people's decreasing attention span. If you feel like it, arrange to meet him for a coffee and a piece of cake; he will certainly look forward to it!