In Practice Who Will Pay The Sunk Costs

While sunk costs should not be treated as part of investment analysis, a firm does need to cover its sunk costs over time or it will cease to exist. Consider, for example, a firm like McDonald's, which expends considerable resources in test marketing products before introducing them. Assume, on the ill-fated McLean Deluxe (the low-fat hamburger introduced in 1990), that the test market expenses amounted to $30 million and that the net present value of the project, analyzed after the test market, amounted to $ 20 million. The project should be taken. If this is the pattern for every project McDonald's takes on, however, it will collapse under the weight of its test marketing expenses. To be successful, the cumulated net present value of its successful projects will have to exceed the cumulated test marketing expenses on both its successful and unsuccessful products.

2. Allocated Costs

An accounting device created to ensure that every part of a business bears its fair share of costs is allocation, whereby costs that are not directly traceable to revenues generated by individual products or divisions are allocated across these units, based upon revenues, profits, or assets. While the purposes of such allocations may be rational, their effect on investment analyses have to be viewed in terms of whether they create

"incremental" cash flows. An allocated cost that will exist with or without the project being analyzed does not belong in the investment analysis.

Any increase in administrative or staff costs that can be traced to the project is an incremental cost and belongs in the analysis. One way to estimate the incremental component of these costs is to break them down on the basis of whether they are fixed or variable, and, if they are variable, what they are a function of. Thus, a portion of administrative costs may be related to revenue, and the revenue projections of a new project can be used to estimate the administrative costs to be assigned to it.

Illustration 5.3: Dealing with Allocated Costs

Case 1: Assume that you are analyzing a project for a retail firm with general and administrative (G&A) costs currently of $600,000 a year. The firm currently has five stores, and the new project will create a sixth division. The G & A Costs are allocated evenly across the stores; with five stores, the allocation to each store will be $120,000. The firm is considering opening a new store; with six stores, the allocation of G & A expenses to each store will be $100,000.

In this case, assigning a cost of $100,000 for general and administrative costs to the new store in the investment analysis would be a mistake, since it is not an incremental cost — the total G& A cost will be $600,000, whether the project is taken or not. Case 2: In the analysis above, assume that all the facts remain unchanged except for one. The total general and administrative costs are expected to increase from $600,000 to $660,000 as a consequence of the new store. Each store is still allocated an equal amount; the new store will be allocated one-sixth of the total costs, or $110,000.

In this case, the allocated cost of $110,000 should not be considered in the investment analysis for the new store. The incremental cost of $ 60,000 [$660,000-$600,000], however, should be considered as part of the analysis.

In Practice: Who Will Pay For Headquarters? As in the case of sunk costs, the right thing to do in project analysis (i.e., considering only direct incremental costs) may not add up to create a firm that is financially healthy. Thus, if a company like Disney does not require individual movies that it analyzes to cover the allocated costs of general administrative expenses of the movie division, it is difficult to see how these costs will be covered at the level of the firm.

In 2003, Disney's corporate shared costs amounted to $443 million. Assuming that these general administrative costs serve a purpose, which otherwise would have to be borne by each of Disney's business, and that there is a positive relationship between the magnitude of these costs and revenues, it seems reasonable to argue that the firm should estimate a fixed charge for these costs that every new investment has to cover, even though this cost may not occur immediately or as a direct consequence of the new investment.

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