Sunk Costs and Opportunity Costs
Two cash-flow rules separate good analysis from bad. A sunk cost is money already spent that cannot be recovered, so it is irrelevant to any forward-looking decision and must be excluded. Clinging to a losing course because of past spending is the sunk cost fallacy. An opportunity cost is the value of the best alternative given up when a resource is committed, and it is relevant, even though no cash changes hands. Building a project on land the firm already owns still costs the rent or sale price that land could have earned. These are cash-based judgements about the future, distinct from the accounting record of what has been booked.
Why it matters
The past is a closed account. If you have already paid for a buffet, the money is gone whether you eat more or stop, so the only sensible question is whether another plate makes you happier or merely sick. That is the sunk cost rule. Opportunity cost is the mirror image. It is the road not taken. Using a spare warehouse for a new project feels free, but if you could have rented it out, the forgone rent is a real cost of going ahead. One rule deletes a number from the past, the other inserts a number the books never recorded.
Formulas
Worked examples
A firm spent US$30 last year on a market study, now complete. The project needs a warehouse the firm already owns and could rent out for US$15 a year. Which figures belong in the valuation?
The US$30 market study is a sunk cost. It was paid regardless of whether the project proceeds, so it is excluded entirely, however tempting it is to want the study to pay off. The US$15 of forgone rent is an opportunity cost and is included as an annual cash outflow, because dedicating the warehouse to the project gives up rent the firm could otherwise collect. Counting the sunk US$30 would wrongly penalise the project, while ignoring the US$15 rent would wrongly flatter it.
Common mistakes
- ✗A large past investment justifies continuing a failing project. That is the sunk cost fallacy. Past spending cannot be recovered and is irrelevant. Only future incremental cash flows should drive the decision.
- ✗Opportunity costs do not count because no cash is paid. An opportunity cost is the forgone value of the best alternative use and is a genuine economic cost, so it belongs in the cash flows even with no out-of-pocket payment.
- ✗A resource the firm already owns is free to use. Using an owned asset gives up whatever it could have earned elsewhere, so its opportunity cost must be charged to the project.
- ✗Sunk costs and fixed costs are the same thing. A fixed cost can still be avoided by not proceeding. A sunk cost is already spent and unrecoverable, which is what makes it irrelevant.
Revision bullets
- •A sunk cost is already spent and unrecoverable, so it is irrelevant
- •Continuing a losing project to honour past spending is the sunk cost fallacy
- •An opportunity cost is the value of the best alternative given up
- •Opportunity costs are relevant even when no cash changes hands
- •An owned resource is not free: charge the rent or sale price it could earn
- •Decisions look forward to incremental cash, not backward to booked costs
Quick check
A company spent US$50,000 on research for a product last year. Deciding whether to launch the product now, that US$50,000 should be
A project will use a building the firm already owns and could otherwise rent out for US$40,000 a year. The correct treatment is to
Connected topics
Sources
- Titman & Martin, Ch. 2Titman, S., & Martin, J. D. Valuation: The Art and Science of Corporate Investment Decisions. Pearson.States that sunk costs are excluded and opportunity costs and side effects are included in relevant cash flows.