“Money already spent is a ‘sunk cost,’ and it is utterly irrelevant to decision making.” – Shlomo Maital
“Sunk costs are irrelevant" is a principle stated in Shlomo Maital’s book Executive Economics and in almost every book on decision making ever written. Despite this well-accepted principle of decision science, most companies continue to include their biggest sunk cost as a major factor in determining product and process costs as well as in other decision making situations. That cost is depreciation expense.
A capital-intensive company’s greatest sunk cost is the money it has invested in its productive capacity. Instead of ignoring this irrelevant cost, however, these companies “pick a life” from the list of allowable asset lives, “pick a method” from the list of acceptable depreciation methods, calculate a depreciation expense and then treat the expense as if it is both an accurate and relevant measure of cost.
The fact is, once it has been purchased, the amount paid for a capital asset is irrelevant. Up to the point of its purchase – before the cost becomes “sunk” – the purchase cost is not only relevant, but critical. The benefits to be gained should be sufficient to provide an adequate return on the funds being invested. Once purchased, however, the amount paid no longer matters. What does matter is how the asset can best be used to generate cash flow for the organization.
There are two ways a capital asset can generate cash for a business organization: it can be sold or it can be used. The value received by selling an asset depends on its market value – not its original cost. The value received by using an asset depends on its money making capability – not its original cost. The asset’s original cost is irrelevant in both cases. So why do companies insist on taking the purchase cost, processing it through a depreciation schedule and assigning it to products and services?
The answer is simple. Accountants – the historians of the business – make them do it. These well-meaning scribes of history, who always keep a sharp lookout in the rear view mirror, want to monitor where the company has been – how good were its decisions. Their objective is not to look through the windshield and provide information to ensure the quality of future decisions. Management, however, needs a clear vision of where it is going. Only by looking forward can management make sure the company is headed towards a successful future. Managers cannot afford to incorporate irrelevant, sunk costs in their decision making processes. Instead they must look forward to future, relevant costs.
The Capital Preservation Allowance
As a company sells its products and services, it must not only generate a return on the owners’ investment, it must also generate the funds necessary to preserve its current productive capabilities. The funds generated from selling today’s products and services should not be viewed as paying for yesterday’s capital outlays; instead, they must be viewed as generating the funds for a critical category of future capital outlays – those necessary to preserve the company’s existing capital base.
In the past, most business executives assumed that by including depreciation expense in product and service cost, they were providing for these future expenditures. But the calculation of depreciation expense has nothing to do with the future – it focuses entirely on past actions! Companies with older assets are probably understating the need for capital funds to simply keep them in business. Companies with newer assets may be providing for more capital than will be needed and, as a result, may be quoting prices that put them into an uncompetitive position.
One answer is for management to look through the windshield – not the rear view mirror – and develop a Capital Preservation Allowance (CPA). This allowance is a forward-looking view of capital requirements that replaces depreciation in the calculation of product and process cost and enables a company to effectively accumulate the funding required from current products and services to preserve existing productive capabilities.