Should you regret the money spent on old equipment? Sunk costs and the right decision
"I paid 30 mln for the oven, I can't just throw it away now": a familiar thought? In economics such spending is called a sunk cost, and it should not affect the decision. Using a café as an example, we compare two options.
Last year Rustam, the owner of the "Shodlik" café, bought a used pizza oven for 30 mln soum. The oven keeps breaking down. The repairman said: "I'll fix it for 8 mln soum, and it will work for another two years." A new oven in the shop costs 25 mln soum.
Rustam's first thought: "I paid 30 mln. If I throw it away and spend more money, those 30 mln will have been wasted."
What is a sunk cost?
It is money that has already been spent and cannot be recovered by any decision. Rustam's 30 mln soum is exactly that: whether he repairs the oven or sells it, the money does not come back.
A simple rule of economics: only money that differs between the options in the future affects a decision. Past spending is the same in both options, so it does not change the choice.
Comparing the two options
Amounts in mln soum, hypothetical. Both ovens are assumed to produce pizza of the same quantity and quality.
| Indicator | A: repair the old oven | B: sell the old one and buy a new one |
|---|---|---|
| Spending now | 8 (repair) | 25 (new oven) |
| Proceeds from selling the old oven | 0 (not sold) | −3 |
| Forgone opportunity to sell | 3 | 0 |
| Service life | 2 years | 5 years |
| Annual repairs and electricity | 6 | 2 |
| Cost over the whole period | 8 + 3 + 2 × 6 = 23 | 25 − 3 + 5 × 2 = 32 |
| Per year | 23 ÷ 2 = 11.5 | 32 ÷ 5 = 6.4 |
Option B is 5.1 mln soum a year cheaper. Last year's 30 mln soum is not in the table: it is the same in both columns, so it drops out of the calculation.
The 3 mln soum in column A is an opportunity cost. If you keep using the old oven, you give up the money you could get by selling it now.
What affects the decision and what does not?
| Amount | Does it affect the decision? | Why |
|---|---|---|
| The 30 mln paid for the oven last year | No | It cannot be recovered and is the same in both options |
| 8 mln for the repair | Yes | Spent only in option A |
| The 3 mln selling price of the old oven | Yes | Received only in option B |
| Future repairs and electricity | Yes | Different between the options |
| Carrying amount in the accounts | Not by itself | A figure derived from the past purchase price; only if it has a tax effect is that effect taken into account |
When the old oven is sold, a loss may appear in the accounts: if the selling price is below the carrying amount. This loss is the result of a past purchase; do not change your decision because of it. Assess separately with your accountant how it affects tax.
The calculation is simplified
We did not take the time value of money into account: 25 mln today and 2 mln three years from now are not the same. If the amounts are large or the periods long, compare the options using net present value (NPV). The logic does not change: the sunk cost does not enter there either.
Where do sunk costs show up in life?
Rustam recalled two examples himself. The first: advertising paid for at the start of the month is not working, but continuing it to the end because "the money has been paid". The second: not closing a loss-making branch because "we have spent so much on renovating it". In both cases the right question is the same: how much will I spend from now on and how much will I get?
Practical tips
- Before every decision, ask three questions: how much do I need to spend now? How much will I get now? Which opportunity am I giving up?
- Compare the options on a per-year basis: if service lives differ, the total amount is misleading.
- Do not add a column for past spending to the decision table at all.
Test yourself
5 questions on this topic: pick an option or reveal the answer.
The monthly fixed costs of the "Qaldirg'och" shoe workshop are 6 000 000 soum, and the variable cost of one pair of shoes is 20 000 soum. If 300 pairs are made per month, what is the average total cost per pair?
Which of the following bakery costs is a fixed cost in the short run (does not depend on the number of loaves baked)?
In a hypothetical country in one year: household consumption spending 500, investment 150, government purchases 200, exports 120, imports 170 (bln units). What is GDP by the expenditure approach?
A hypothetical dairy workshop made 400 cheeses in a month: total cost was 12,000,000 soums, of which fixed cost was 4,000,000 soums. What is the average total cost (ATC) per cheese?
In a hypothetical country in one year state budget revenues were 210 billion, expenditures 240 billion units, and GDP 1,500 billion units. What percent of GDP is the budget deficit?
Answered: 0 / 50 of 5 correct
All tests →See also
Sources
- Example, amounts and calculations · compiled by the author, hypothetical