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Sunk costs

Article  in  Appita Journal · April 2010

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Sunk costs
This paper, by GEOFF COVEY1 was presented at the 53rd Appita Annual Conference and Exhibition,
Melbourne, April 2009
Sunk costs are expenditure that has already been made with
some objective, but which cannot be recovered if that objective
is abandoned. By their nature they relate to a specific objective
(e.g. a non-refundable deposit on a particular piece of land or
equipment) such that a decision not to proceed with the purchase
will result in the forfeiture of the deposit. In some cases only part
of the expenditure is lost – e.g. in the purchase of equipment, it
might be possible to transfer part of the deposit for the purchase
of more expensive equipment.
An everyday example of a sunk cost is a ‘no changes permitted’
airline ticket. If one no longer needs or wants to take the trip for
which the ticket was booked, then the money is lost (sunk). Even
if one decides to take the trip anyway, but without any purpose, the
money should be regarded as sunk because neither the original
objective, nor any reasonable alternative objective has been met.
A slightly more complex situation arises with ‘partially flexi-
ble’ fares. Here the ticket is not refundable, but can be credited
towards another ticket with the same airline of equal or greater
value, provided that a re-booking fee is also paid. In this case, if
the original flight is no longer required, in which case the entire
purchase cost is lost (sunk), or the re-booking fee is paid in
which case only an amount equivalent to the re-booking fee can
be regarded as the equivalent of sunk.
The concepts and consequences of sunk costs are generally
quite simple, but many bad business decisions are made because
of improper consideration or treatment of sunk costs.
Properly, sunk costs must be treated as irretrievable and part
of the past. Any decision involving circumstances in which costs
have already been sunk should be made on the basis of ignoring
costs which have already been sunk and considering only
future expenditure.
Failure to treat the issue of sunk costs is sometimes due to a
poor understanding of the economic analysis of the case, but it
often has a strong subjective (or emotional) component. There is
a tendency to ignore proper economic analysis and instead be
swayed by one of the following:
• ‘Honouring sunk costs’ (not wanting to spoil the ship for a
ha’penny-worth of tar). This is a tendency to stick with the
original plan even though the circumstances have changed
(1,2) (it is interesting to note that much of the literature on
this aspect of the issue has been published in journals related
to psychology or philosophy rather than economics).
• Abandonment (not throwing good money after bad). This is
a tendency to over-compensate and to completely abandon
the investment rather than to consider ways of making a par-
tial recovery of costs (3).
This paper will attempt to show how sunk costs should be
treated objectively and to provide simple examples of how fail-
ure to do this can result in poor financial decisions. It is stressed
that most of the concepts presented here can be found in standard
1Chairman
Covey Consulting Pty. Ltd. 1st Floor, 660 High St. Kew VIC 3102
98 Appita Journal
text books and references, but experience shows that the con-
cepts are poorly understood and many inappropriate decisions
are made as a result.
WHEN SUNK COSTS BECOME IMPORTANT
The first thing to understand is that sunk costs usually only come
into consideration after the decision to undertake a project and after
expenditure has been made. An exception to this should be the
recognition before starting work that such exercises as research and
feasibility studies will be sunk costs whatever the outcome.
Sunk costs usually become important because something has
gone wrong; the project has not worked as expected, market con-
ditions have changed or the company’s objectives have been
changed. In these cases the attractive return on investment that
was predicted a priori will no longer be met and a decision must
be made as to what is to be done with the assets of the project
under current circumstances.
When this happens, the costs expended in the past are irrele-
vant.
All that is relevant is future costs and income.
Obviously, a company that keeps making investments and
then writing off large chunks of expenditure and proceeding
purely on the basis of future cash flow will not stay in business
for very long. The objective must be to salvage the maximum
value when things have not turned out as expected.
(In the examples that follow, simple return on original invest-
ment type comparisons are made. A discounted cash flow
approach is, of course, more appropriate but the differences are
relatively small for most of the examples and the objective is to
keep the analysis as simple as possible. Use of DCF methods
would not alter the principles of the issues to be considered).
A hole in the ground
Based on seismic surveys and test drillings, a mining company
has invested AUD 3 million in sinking a deep mine shaft to
exploit a valuable mineral deposit. Unfortunately, when the shaft
is completed it is found that the actual deposit is of poorer grade
and worse mineralisation than survey work had indicated and it
is not worth proceeding further.
A geological research group needs a deep hole to position
geo-monitoring equipment, and offers the company AUD
200,000 for the mine shaft.
As this represents less than 7% of the cost of sinking the shaft,
the company rejects the offer.
This is a fallacy, and an example of confusing cost with value
(4), as well as a failure to understand sunk costs (in this case lit-
erally). The hole may have cost AUD 3 million to dig, but with
no resources at the bottom its value is zero. Further, it is not an
asset that can be used in a different way by the company (mine
shafts cannot be relocated to a more promising site).
The company should accept the offer of AUD 200,000
because, irrespective of the cost of sinking the shaft, the offer is
AUD 200,000 more than the value of the hole.
Vol 63 No 2

Let it rot?
A farmer has cultivated, planted the seed and applied fertiliser
and insecticides at a total cost of AUD 30,000. All that remains
is to spend another AUD 10,000 in harvesting the crop.
Before he planted, the anticipated selling price of the crop
was AUD 60,000 and he expected a profit of AUD 20,000 (this
analysis ignores opportunity costs for the field).
However, the yield in his area is lower than normal, while
there is a glut of produce elsewhere, and the anticipated selling
price is now only AUD 25,000. Should he harvest or allow the
crop to rot?
Had he known the real value of the harvested crop in advance,
the farmer would not have planted. However circumstances have
changed and costs incurred to date should be ignored. His real
choice is do nothing and lose no further money, or to spend an
additional AUD 10,000 to generate AUD 25,000.
He should harvest and only be down AUD 15,000 on the year
rather than let the crop rot and be down AUD 30,000.
This is a case where good money should be thrown after bad
to reduce overall loss.
Pointless advertising
You have spent AUD 500,000 advance advertising a new,
patented product for which you have sole agency to import.
Now the company which owned the patents and was to have
manufactured the product has gone bankrupt and stopped all
operations.
What can you do about it? Probably nothing.
What is the value of the advertising? Probably nothing.
The non-refundable deposit
You have agreed to buy some equipment for AUD 100,000 and
have paid a non-refundable deposit of AUD 30,000.
You have now been offered the same piece of equipment by
another supplier for AUD 75,000. What should you do?
This can be looked at in two ways, and both show that you
should complete the original purchase.
To have the equipment, you can either complete the original
purchase for an additional outlay of AUD 70,000 (the deposit is
a sunk cost) or you can switch to the low supplier for an outlay
of AUD 75,000.
An alternative way of looking at this which avoids the con-
cept of sunk costs in the normal sense is to consider that the cost
of going with the new supplier is AUD 105,000, being the actu-
al purchase price plus the cost of forfeiting the deposit. The cost
of going with the original supplier remains at AUD 100,000.
The cancelled reactor
You are planning to build a new manufacturing plant that
includes an unusual high temperature reactor using chlorine as
a reactant. For this purpose you have purchased 500kg of plat-
inum sheet and delivered it to the fabricator.
Because of the economic down-turn, the project is suddenly
cancelled.
The fabricator offers you 50% of the purchase price for the
platinum sheet (platinum prices have been stable since you
bought the material). Should you take it?
NO. This is not a sunk cost situation. Raw materials have been
purchased, but are still in original form. It should be possible to
April – May 2010
Feature
re-sell them for much more than half their purchase price.
Suppose the circumstances are as before, except that fabrica-
tion of the reactor vessel is nearly complete, and the fabricator
still offers you 50% of the material value for it.
You should still not accept. Scrap platinum is usually worth
much more than 50% of merchant stocks (a search of the web
will show dealers offering about 80% of spot price for industri-
al platinum scrap).
The plant also had a similar configuration reactor made from
low grade stainless steel. Fabrication is almost complete when
the project is cancelled. Again the fabricator has offered 50% of
the material value.
This time you probably should take the offer. The reactor is
unlikely to be useful to anyone else and so the fabrication costs
should be regarded as sunk. The value of the reactor is only its
scrap value and for low grade stainless steel, 50% is probably a
good price.
The obsolete filter
Your mill purchased a new leaf filter for AUD 400,000 two
years ago. Another manufacturer has brought out a much
improved alternative that only costs AUD 240,000 to buy and
has an operating cost of AUD 18,000 a year (compared with
AUD 30,000 for the present filter).
Should you replace the filter?
This particular problem can be looked at in several ways.
Firstly on the basis of conventional profit analysis (figures in AUD):
Existing filter New filter
Purchase cost 400,000 240,000
Life when new 10 10
Depreciation 40,000 24,000
Ann op cost 30,000 18,000
Years in use 2 0
Total annual cost 70,000 42,000
Simple profit considerations suggest that the filter should be
replaced. Similarly, cash flow analysis also suggests replacement.
However, this is not the correct way to analyse the situation.
The existing filter has already been purchased and the deprecia-
tion charges applied to it are not true costs. To compare the total
annual costs for the filter that has already been purchased with
the new one, depreciation should be included for the new filter
but not for the existing filter because the purchase price of the
existing filter is a sunk cost, but the purchase of the alternative
filter lies in the future and is not a sunk cost.
On this basis, the annual cost of the existing filter is reduced
to AUD 30,000, while the annual cost of the new filter is
unchanged at AUD 42,000.
The analysis above is somewhat oversimplified as it ignores
various scrap value and tax benefit issues. A more complete
analysis is as follows:
The filter has been operating for two years; therefore if it is
being depreciated at 10%/year straight line, the book value of
the filter would be AUD 320,000.
Suppose it can be sold second hand for AUD 50,000, then the
loss on disposal would be AUD 270,000.
At a tax rate of 30%, this results in a tax credit of AUD
81,000. This credit and the sale proceeds can be applied to the
purchase of the new filter (bringing the cost of changing over
99
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down to AUD 109,000) and the rest of the loss on disposal is ing with the sunk cost of the original investment.
written off (it is a sunk cost). The following table ignores sunk costs and looks at cash-
In this case the comparison becomes (figures in AUD): flows for the seven year remaining life of the existing plant
Existing filter New filter Cashflow(AUD million) Keep old Displace
Net purchase cost 109,000 Year 1 -50
Life when new 10 10 3 13
Depreciation ignore 10,900 Year 2 3 13
Ann op cost 30,000 18,000 Year 3 3 13
Years in use 2 0 Year 4 3 13
Year 5 3 13
Total annual cost 30,000 28,900 Year 6 3 13
Year 7 3 13
The depreciation used above is not the value for tax purposes, Total 21 41
but it gives the most favourable ‘proper’ case for purchasing the
new filter. There is now a slight benefit in replacing the filter. Clearly, the concern about depreciation is irrelevant and the exist-
Suppose instead, the original filter has nor been delivered yet ing facility should be displaced by one using the new technology.
and the order can be cancelled at a cost of 25% of the purchase In fact, the table understates the benefits of going to the new
price (figures in AUD): technology, as there will also be the tax advantage of an immedi-
Go with existing Buy new plus ate write-off of the old facility, and the displacing plant will still
cancellation fee have three years of life after the seven years considered above.
Purchase cost 400,000 240,000
Cancellation fee 100,000 Good money after bad
Cost incl canc fee 340,000
Life when new 10 10 A company spent AUD 10 million on a project with an antici-
Depreciation 40,000 34,000 pated profit of AUD 1 million/year. However, the plant can only
Ann op cost 30,000 18,000 be operated at low throughput and is generating a loss of AUD
Years in use 2 0 1.5 million/year.
The problem has been traced to one section of the plant which
Total annual cost 70,000 52,000 is inappropriate for the actual (rather than anticipated) operating
conditions. This problem can be resolve by the expenditure of a
In this case it does make more sense to cancel the existing further AUD 1 million after which the plant will generate a prof-
order and buy the new model filter. it of AUD 0.7 million/year.
Note in the above analysis, the cancellation fee has been What should the company do?
added to the cost of the new filter as it is not incurred if the orig- Standard analysis would be:
inal order proceeds. It is also assumed that for comparison pur- If proceed:
poses (but not for tax) the cancellation fee is written off over the Total cost AUD 'million 11
life of the equipment. Profit AUD 'million/year 0.7
Return on investment 6.36%
Displace or replace
The previous example is one where errors in decisions are very This return on investment is too low, spending more would
commonly made (including errors not to change equipment be throwing good money after bad, and the project should be
even though this is the proper option). Many examples can be abandoned.
found in the literature e.g. Humphreys (5) who refers to the This is wrong.
problem as ‘Displacement Vs Replacement’ (Replacement If the project is abandoned, the AUD 10 million will be lost
being substituting for a worn out item, and Displacement being anyway, so it should be left out of the consideration (it is a sunk
substituting for an item that is still functional, but not econom- cost). This also means that depreciation of the past AUD 10mil-
ic). Levine (6) gives a qualitative discussion of a real (but dis- lion should also be neglected. So the current cash flow is -AUD
guised) case where a poor decision was made because some 0.5million – still too low.
equipment had not been fully written off. Consider the case of performing the remedial work and treat-
A similar case, but analysed quantitatively follows: ing sunk costs correctly:
A company spent AUD 50 million three years ago building a This is now a project where only AUD 1million is to be
production facility. There are still seven years of depreciation to spent. Only depreciation on this additional investment is con-
be written off and the plant has negligible scrap or resale value. sidered. Therefore the cash flow from the upgraded plant is
The technology used in the facility was made obsolete almost AUD 1.8 million/year and the profit is AUD 1.7 million/year.
immediately and it is now making a loss of AUD 2million/year, The investment outcome can be summarised thus:
with a positive cash flow of AUD 3million/year. Capital cost 1
It is possible to adopt the technology being used by competi- Depreciation 0.1 On new investment only
tors by building a new plant costing AUD 50million which Cash flow 1.8
would generate a profit of AUD 8million/year (and a cash flow Profit 1.7
of AUD 13 million/year). Return on investment 170% Pretty good!
Although the old plant is not fully depreciated, the important
point here is that depreciation is not a real cost, and we are deal- Obviously the upgrade should be undertaken.
100 Appita Journal Vol 63 No 2

A tale of two miners
Two interesting cases arise from BHP Billiton.
In November 2008 BHP Billiton abandoned its year-long
take-over bid for Rio Tinto. In doing so it wrote off some AUD
3-600 million invested in the deal.
This is a powerful example of a sunk cost and of a response
to changing circumstances. When BHP Billiton launched its bid
the commodities markets were booming and both companies
appeared to be in strong positions. The commodity prices
slumped and the values of shares in both companies followed
them down. Rio Tinto faced the problem of servicing large
amounts of debt (which has resulted in it selling off assets).
BHP Billiton decided that the offer was no longer in the inter-
ests of its share holders and withdrew its offer.
This was a clear case where circumstances had changed dra-
matically since the original decision was made and the compa-
ny decided to abandon the money already spent rather than to
‘throw good money after bad’.
Probably the company was also cautious after its experiences
with changing commodity prices shortly after it purchased
Magma Copper.
BHP purchased Magma Copper in 1996 when copper prices
were at about USD 2600/t and rising.
Almost immediately copper prices steadied and then began a
severe decline. Through the first half of 1999 prices were in the
USD 1400-1500/t and BHP stopped production at the San
Miguel smelter in Arizona and put the plant onto ‘care and
maintenance’.
For the next four years copper prices remained fairly steady
at this low price, and in October 2003 BHP announced the per-
manent closure of its Arizona copper operations and the demo-
lition of the smelter.
There was an immediate rise in copper prices, at first thought
just to be a market reaction to one large producer withdrawing.
But the rise continued and by February 2004, copper prices
were higher than when BHP purchased Magma. From April
2006 to September 2008 copper traded at between USD 5700/t
and USD 8400/t (usually towards the upper end of this range.
After this the price of copper plummeted in response to the
world financial crisis, but in early February 2009, it was still
trading at above USD 3300. The price of copper and dates of
BHP’s actions are shown in Figure 1.
With hindsight, the decision to demolish the smelter was a
bad one and made at just the wrong time. Had BHP waited
another three months they would probably have restarted it
instead. However, in terms of the treatment of costs as sunk, at
the time when the final decision was made, the action was prob-
ably correct. BHP had spent AUD 3.2 billion to buy what looked
like a sound asset. Shortly after the purchase the gains in the
market reversed and copper fell to a price that made production
$10,000
BHP purchases Magma
$9,000
$8,000
$7,000
Plant on care
$6,000 and maintain
$5,000
$4,000
$3,000
$2,000
$1,000
$0
1993 1995 1998 2001 2004 2006
Fig. 1 Copper prices since 1993, and BHP’s actions with
Magma Copper (Copper prices from Indexmundi)
April – May 2010
View publication stats
Feature
uneconomic and stayed there for four years. BHP tried unsuc-
cessfully to sell the smelter. By late 2003 they had mines and a
smelter that were uneconomic to operate and which no one
wanted to purchase; irrespective of what BHP had paid for
them, their value was zero. Further, continuing care and mainte-
nance was costing the company money and the longer a plant
remains in this mode the more difficult and expensive it is to
restart it.
At the time it was made, the decision to regard the purchase cost
as sunk and to stop throwing good money after bad was correct.
This example shows several important points about sunk
costs and irreversible decisions. The original purchase of
Magma Copper was based on past copper prices and reasonable
expectations of future prices. Shortly after the purchase the mar-
ket unexpectedly entered a prolonged slump. BHP attempted to
sell the assets for less than they had paid – i.e. recognised that
the original purchase price was a sunk cost and that this cost had
no bearing on the current value of the assets. At the time of the
decision to demolish the value of the assets were effectively nil
and BHP stopped further expenditure.
The decision to demolish was one to formally sink the invest-
ment. It is unfortunate for BHP that copper prices then rose after
it was too late for them to benefit.
This illustrates the point that the special treatment of sunk
costs normally only matter if circumstances change after the
investment decision was made. It is also quite possible that after
the decision to dispose of an asset that there will be further
unforseen changes in circumstances.
World scale, commodity machines only
A final example may be seen from the attitude of the paper
industry towards old machines.
The last 30 years has seen the local industry (and the indus-
tries in many other developed countries) shut down small
machines because they no longer fit (often after the machine
was switched from making low tonnage but profitable products
to commodity grades for which it was not suited).
There was an opportunity that was rarely taken or even consid-
ered to recognise that the machine was now available at zero cost
and switch in opposite direction to high margin specialty grades.
CONCLUSIONS
Two important lessons should come from this paper:
Firstly, certain types of expenditure, such as research and
advertising, are sunk costs from the moment that they are made,
and if the project does not proceed these costs can rarely be
recovered.
Secondly, when the real world differs from that assumed
when the decision to implement the project was made, past costs
should be ignored when planning future strategies about the pro-
ject assets.
REFERENCES
(1) Knox, R.E. and Inkster, J.A. ‘Postdecision dissonance at post time’ Journal
of Personality and Social Psychology 8:319-323 (1968)
(2) Bass, R ‘Sunk Costs’ Department of Philosophy, Costal Carolina
University, www.geocities.com/amosapient/sunkost.pdf
(3) Bruno, S and De Lellis, A ‘The economics of ex ante co-ordination’
Workshop on ‘Systems of Innovation’, EU, CNRS-LATAPSES,
Shut and Dipartimento di Scienze Economiche dell'Università di Bologna, Bologna
demolish 5-6 October 1992
(4) Shore, D. and Covey, G. ‘Balancing Cost and Value’ Proc. 60th Appita
2009 2012 Conference, Melbourne, 2006, p119.
(5) Humphreys, K.K. Jellen’s cost and optimisation engineering 3rd Edn.
McGraw-Hill, 199, p196 et seq.
(6) Levine, H.A. ‘Sunk costs don’t matter’ PM World Today XI(1) (Jan 2007).
101