Sunk Costs

A sunk cost, by definition, is a cost we have already paid or have already incurred the liability to pay. Such a cost cannot be changed by the decision today to accept or reject a project. Put another way, the firm will have to pay this cost no matter what. Based on our general definition of incremental cash flow, such a cost is clearly not relevant to the decision at hand. So, we will always be careful to exclude sunk costs from our analysis.

That a sunk cost is not relevant seems obvious given our discussion. Nonetheless, it's easy to fall prey to the fallacy that a sunk cost should be associated with a project. For example, suppose General Milk Company hires a financial consultant to help evaluate whether or not a line of chocolate milk should be launched. When the consultant turns in the report, General Milk objects to the analysis because the consultant did not include the hefty consulting fee as a cost of the chocolate milk project.

Who is correct? By now, we know that the consulting fee is a sunk cost, because the consulting fee must be paid whether or not the chocolate milk line is actually launched (this is an attractive feature of the consulting business).

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