Sunk Costs in Investment Decisions

A sunk cost is an expenditure already incurred that cannot be recovered, regardless of the decision now taken. Because present choices can alter only future outcomes, investment appraisal should compare the incremental future costs and benefits of available alternatives rather than attempt to justify past spending.

Forward-looking decision rule

A rational investment decision selects the feasible option with the highest expected net present value, after discounting future incremental cash flows and accounting for risk.

• An unfinished project should continue only when its expected future benefits justify its remaining construction, operation and other avoidable costs.
• The original acquisition or construction expenditure is excluded if it cannot be recovered under any current alternative.
• When capital is limited, projects must also be compared with the returns available from the best alternative use of funds, which represents the opportunity cost.

Why sunk costs do not affect the choice

A genuinely sunk cost is identical under every option, such as continuing, modifying or abandoning the project. It therefore cancels out when alternatives are compared and cannot change their relative attractiveness.

• Including past expenditure can produce the sunk-cost fallacy, in which further resources are committed merely because substantial resources have already been spent.
• Past expenditure may provide information about costs, delays or demand, but the decision-relevant element is the resulting revision of future expectations, not the expenditure itself.

Application to energy infrastructure

Energy projects often involve large, irreversible capital expenditure, making disciplined reassessment especially important. A partly completed plant should not be continued merely to protect past investment if another option now offers greater prospective value.

• Expected completion costs, fuel costs, operating expenses and future revenues or social benefits remain relevant because they can still vary with the decision.
• Recoverable salvage value, alternative-use value, contractual exit payments and decommissioning liabilities are not sunk when the present choice can still affect them.
• The historical purchase price of an asset is sunk, but its current sale value is relevant because retaining the asset sacrifices that value.