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Why should sunk costs be ignored in future decision making?

Modified on: 2018/07/16
A:

A sunk cost is a cost that cannot be recovered or changed and is independent of any future costs a business may incur. Since decision-making only affects the future course of business, sunk costs should be irrelevant in the decision-making process. Instead, a decision maker should base her strategy on how to proceed with business or investment activities on future costs.

For example, suppose a business executive of a finance consulting company is hired to build a financial analytics application and will receive $10 million at the end of the project. The business executive determines it will cost $7 million in total to finish the project and take one year. The company will profit $3 million for completing this project.

However, in the ninth month of operation, her team runs into problems with the main framework of the application. The firm already spent $5.25 million on this project, and the business executive must decide whether to continue with the project or cancel it. She estimates that this major setback will cost an extra $1 million. However, the company can still profit $2 million from the project.

Whether the business executive decides to continue with the project or cancel it, the costs spent for the nine months of operation cannot be retrieved. This should be irrelevant to her decision because only future costs and potential revenues should be considered. If she cancels the project, the company would incur a $5.25 million loss and have revenues of $0. If she continues with the project, the future revenue for the company is $10 million, and future costs are only $2.75 million.

She decides to continue with the project because it is a 3.64 return on investment, ignoring sunk costs. The consulting company delivers its application to the hirer and receives revenues of $10 million and has a profit of $2 million.


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