Sunk Costs

Past costs, also known as sunk costs, are not relevant in decision making because they have already been incurred; therefore, these costs cannot be changed no matter which alternative is selected.

For instance, if the B&B owner has paid a firm to do a feasibility study for four alternatives: do nothing, convert to a gift shop, convert to room without a bath, convert to room with a bath, and the cost of that study was $10,000, there is no reason to include that cost in any short-term differential cost analysis since it has already been incurred and paid and is a cost regardless of the choice made.

The concept seems simple enough, but including sunk costs in the decision-making process can be tempting. For example, suppose you buy a well-used Geo Metro for $500 and then spend $1,600 on repairs and new tires, but it sputters and dies and you have to spend another $200 to get it towed to a mechanic who tells you the car needs another $1,200 in repairs to operate safely, and will probably need additional repairs of $100 per month for the next two years, and then it will have to be taken off the road. Your alternatives are to (a) get the repairs completed or (b) trade in the car for a newer used car.

A dealer has told you the trade-in value of your old car will be $200. The newer used car will require you to make monthly payments of $250 for two years. At the end of two years, it will be worth about 50% of the initial cost.

In analyzing your two alternatives, what costs do you consider?

It’s tempting to think that the $2,100 you have already spent (note the past tense) is relevant: you already have that much put into it, and you don’t want to lose that money, but in reality, that money is already gone–it is a sunk cost; a consequence of a past decision.

In reality, the relevant costs for each alternative are the following:

1. $1,200 in current repair costs to keep your current car plus $2,400 in additional repairs over the next two years for a total of $3,600 with no residual value, and
2. 24 payments of $250 minus $200 for the trade-in minus $3,000 residual value for a total net outlay of $2,800 to buy a newer used car.

Obviously, you also would consider non-financial (qualitative) factors, such as the additional prestige, safety, and improved driving experience of having a newer car, and to make the calculation more precise, you should also factor in the time value of money.

The point of not including sunk costs is that they are not going to change or be avoidable. Under either scenario, the $2,100 spent on the car and repairs prior to this decision-point are the same.

Future Costs that do not differ between alternatives

Future costs that do not differ between alternatives are irrelevant and may be ignored since they affect both alternatives similarly.

For example, suppose the B&B owner also had an option to convert the spare room into either a room with a bath or a room without a bath (that would use a shared bath upstairs). In a differential analysis, we could leave the variable cost (housekeeping) out of the decision-making process since it would be the same (presumably) for both, and we could leave out the initial cost if it was the same for both (which it would likely not be).

Of course, if rooms with a bath cost more to keep up than rooms without, the housekeeping variable cost becomes relevant again.

Also, if we want to assess cash flows for other reasons, such as future valuation, we’d put the variable costs back in again (we’ll assume the remodel costs are the same as the guest room/gift shop analysis):

Looking at this additional information, the guest room with a bath seems like the obvious winner, if that is feasible.

For a review of sunk costs, watch:

You can view the transcript for “Sunk Costs” here (opens in new window).

For a quick overview of relevant costs, watch:

You can view the transcript for “Relevant Costs (Managerial Accounting)” here (opens in new window).

Now, check your understanding of sunk costs and other irrelevant information.