Fixed and Sunk Costs

9,000/150,000, or 6 percent. Although this return is positive, the investment remains unprofitable because its return is well below the normal 10 percent requirement.

Now suppose the investment’s return is 12 percent; that is, its accounting profit is $18,000. In this case, the project delivers a 2 percent “excess” return (that is, above the normal rate) and would be economically profitable. Finally, suppose the project’s accounting profit is exactly $15,000. Then its economic profit would be exactly zero: $15,000 (.1)($150,000) 0. Equivalently, we would say that the project just earned a normal (10 percent) rate of return.

Costs that are fixed—that is, do not vary—with respect to different courses of action under consideration are irrelevant and need not be considered by the manager. The reason is simple enough: If the manager computes each alternative’s profit (or benefit), the same fixed cost is subtracted in each case. Therefore, the fixed cost itself plays no role in determining the relative merits of the actions. Consider once again the recent graduate who is deciding whether to begin work immediately or to take an MBA degree. In his deliberations, he is concerned about the cost of purchasing his first car. Is this relevant? The answer is no, assuming he will need (and will purchase) a car whether he takes a job or pursues the degree.

Consider a typical business example. A production manager must decide whether to retain his current production method or switch to a new method. The new method requires an equipment modification (at some expense) but saves on the use of labor. Which production method is more profitable? The hard (and tedious) way to answer this question is to compute the bottom-line profit for each method. The easier and far more insightful approach is to ignore all fixed costs. The original equipment cost, costs of raw materials, selling expenses, and so on are all fixed (i.e., do not vary) with respect to the choice of production method. The only differential costs concern the equipment modification and the reduction in labor. Clearly, the new method should be chosen if and only if its labor savings exceed the extra equipment cost. Notice that the issue of relevant costs would be very different if management were tackling the larger decision of whether to continue production (by either method) or shut down. With respect to a shut-down decision, many (if not all) of the previous fixed costs become variable. Here the firm’s optimal decision depends on the magnitudes of costs saved versus revenues sacrificed from discontinuing production.

Ignoring fixed costs is important not only because it saves considerable computation but also because it forces managers to focus on the differential costs that are relevant. Be warned that ignoring fixed costs is easier in principle than in practice. The case of sunk costs is particularly important.

A sunk cost is an expense that already has been incurred and cannot be recovered. For instance, in the earlier factory example, plant space originally may have been built at a high price. But this historic cost is sunk and is irrelevant to the firm’s current decision. As we observed earlier, in the case of excess, unused factory capacity, the relevant opportunity cost is near zero.

More generally, sunk costs cast their shadows in sequential investment decisions. Consider a firm that has spent $20 million in research and development on a new product. The R&D effort to date has been a success, but an additional $10 million is needed to complete a prototype product that (because of delays) may not be first to market. Should the firm make the additional investment in the product? The correct answer depends on whether the product’s expected future revenue exceeds the total additional costs of developing and producing the product. (Of course, the firm’s task is to forecast accurately these future revenues and costs.) The $20 million sum spent to date is sunk and, therefore, irrelevant for the firm’s decision. If the product’s future prospects are unfavorable, the firm should cease R&D.

Perhaps the last word on sunk cost is provided by the story of the seventeenthcentury warship Vassa. When newly launched in Stockholm before a huge crowd that included Swedish royalty, the ship floated momentarily, overturned, and ignominiously (and literally) became a sunk cost.

Business Behavior: Sunk Costs

Sunk costs are easy to recognize in principle but frequently distort decisions in practice. The construction of nuclear power plants in the 1970s and 1980s illustrates the problem. New plant construction was plagued by cost overruns and safety problems. (Indeed, after the Three Mile Island accident in 1979, safety concerns and strict safety regulations contributed to the overrun problem.) At the same time, revenue projections declined due to the low prices of alternative energy sources, oil and natural gas. While no new plants were initiated in the 1980s (because of worsening profit prospects), many utilities continued to spend on plants already in progress, despite equally dim profit predictions. In light of uncertain profits and looming losses, making the right decision—to continue construction or abandon the effort— wasn’t easy. (As the unrepentant actress Mae West once said, “In a choice between two evils, my general rule is to pick the one I haven’t tried yet.”) In some cases, utilities abandoned plants that were 85 percent complete after having spent more than $1 billion. Yet looking forward, this might be a perfectly rational decision. By contrast, construction of the Shoreham nuclear plant on Long Island continued to completion despite severe cost escalation and safety concerns. With an accumulated cost bill of $6 billion by 1989, it never received regulatory approval to operate, and the enormous sums spent came to nothing.

Research by psychologists testing the decision behavior of individuals including business managers clearly shows that sunk costs can adversely affect judgment.3 For instance, executives will choose rightly to make a substantial initial investment in a simulated project, such as new product development, an R&D effort, or a capital investment. Yet, they continue to make cash investments even when new information in the simulation is highly unfavorable. By contrast, executives who enter the simulation only at the second decision with the same information (here, previous management has made the initial decision) are much more likely to pull the plug and write off the investment. The moral is clear; it’s difficult to be objective when one is already psychologically invested in the initial decision (the more so the larger the initial sunk cost). Initial investors tend to maintain an overly optimistic outlook (despite the unfavorable new information) and adhere to the status quo established by their initial decision. Sunk costs also have effects in other contexts. For instance, in ongoing business disputes ranging from labor impasses to law suits, the rival parties frequently dig in as costs accumulate and refuse to settle (even when it is in their self-interest), thereby escalating the conflict.

Government spending programs, particularly in energy, defense, and basic science face similar challenges. During the 1980s and 1990s, the U.S. government halted public spending on scores of energy projects, including almost all synthetic-fuel programs ($25 billion spent). In 1989, Congress authorized the largest pure science project ever undertaken, the Supercollider program. Unhappily, the project’s cost estimates obeyed their own law of acceleration, rising over the years from $4.4 billion to $6 billion to $8.2 billion to $11 billion to $13 billion. In 1993, with $2 billion already spent and 15 miles of underground tunnels dug, Congress voted to abandon the program. Nonetheless, some weapons programs seem to have nine lives— refusing to die even when their original Defense Department sponsors have recommended cancellation. The futuristic Airborne Laser, conceived in the 1980s to shoot down enemy ballistic missiles, is a case in point.4 Since 1996, the Pentagon has spent some $5.2 billion on the program with only a poorly performing test aircraft to show for it. Believing the concept to be unworkable, the Clinton, Bush, and Obama administrations have all recommended cancellation. Yet defense contractors, the locales where the development work is being done, and proponents in Congress have all lobbied hard to continue funding.

In recent years, the budget axe has been used effectively in scrapping a number of uneconomical large-scale programs. Nonetheless, as critics point

3For research on decision making and sunk costs, see H. Arkes and C. Blumer, “The Psychology of Sunk Cost,” Organizational Behavior and Human Decision Process, 1985, pp. 124–140; and W. Samuelson and R. Zeckhauser, “Status Quo Bias in Decision Making,” Journal of Risk and Uncertainty (1988): 7–59. 4This discussion is based on N. Hodge, “Pentagon Loses War to Zap Airborne Laser from Budget,” The Wall Street Journal (February 11, 2011), p. A1.