3.1 Relevant cash flows and sunk costs
When carrying out a quantitative investment appraisal, you need to work out which costs and revenues should be included in the analysis. Costs and revenues that should be included are called relevant cash flows.
Activity 5 Relevant costs and revenues
Name three characteristics that a relevant cost or revenue has.
- It must be a cash flow. This excludes accounting charges such as depreciation, which aim to reflect how an asset is used over its economic life and do not affect actual cash flows, whereas we are only interested in the timing of cash being paid or received.
- It must be incremental This means that a cash flow will change, as a result of making a decision. Costs or revenues which will take place regardless of the decision made are not incremental.
- It must arise in the future. Costs or revenues which have already occurred cannot be affected by a decision taken now, so they are irrelevant to decisions about the future.
The main principle to remember is that you want to know what will happen to cash flows if one decision is taken compared with an alternative decision. (This alternative could be the status quo or it may be an alternative project under consideration). In order to decide if a cash flow is relevant, ask yourself: ‘How will a cash flow change as a result of this decision being made?’ If the answer is that it won’t change, then it is not a relevant cash flow for that particular decision.
A cost which has already been incurred (so is a past not a future cash flow), is called a sunk cost and is not relevant. In addition a cost which has not occurred yet, but cannot be avoided in the future regardless of the decision, is also a sunk cost. Even though it is a future cash flow, it will be incurred irrespective of the decision made, so is not relevant to the decision.
Also note that the relevant cash flow is the only part of a cash flow that will change depending on the decision. This may not be the entire cash flow. For example if a new machine will reduce the raw materials used in production from £20,000 to £15,000, the relevant cash flow is a saving of £5,000: the incremental difference between the figures. Similarly, overheads such as salaries, heating, etc. are only included if they will increase or decrease if the project goes ahead. Even then, only the change in cash flow is relevant to the calculations used in investment appraisal.
Relevant costs (cash outflows) of a project could include:
- the initial investment in purchasing new equipment
- extra staff costs for manning new equipment or providing new services
- additional infrastructure or marketing to support the new goods or services provided
- additional tax payable on any expected profits from a project
- an increase in working capital required as a result of a project (a factor that is often ignored!)
- revenue which would have been earned if the project did not go ahead, which is no longer earned due to a project going ahead. This revenue is called an opportunity cost of the project.
Relevant revenue (cash inflows) includes:
- increases in revenue
- reductions in cash outflows due to cost savings, e.g.:
- less raw material to be purchased in the future
- reductions in staff labour time which result in lower staff cost
- reduction in overheads which can be directly attributed to the project – for example, reduction in energy cost or fuel cost due to greater efficiency
- cash flow from the disposal of old equipment
- working capital released at the end of a project (note this may be lower than the working capital required at the beginning of the project).
Box 3 The fallacy of sunk costs
The logic of ignoring sunk costs is clear; and taking them into account is called a fallacy – a faulty argument. However, it is a fallacy humans are very prone to making and can be difficult to overcome. It often results from reluctance to waste money that has been previously spent (Arkes and Blumer, 1985) or being viewed by others as wasting it. In reality, money that has already been spent is gone, and wasting more money to attempt to recoup some does not make sense. Making further investment, on the basis that money has been spent in the past (i.e. on sunk costs), is sometimes known in English by the phrase ‘throwing good money after bad money’. In fact most languages have some equivalent phrase, which probably shows how tempting and widespread this fallacy is! Note that those responsible for previous spending may have a personal incentive to push for further spending to achieve something from a project in order to avoid criticism of their previous decisions.
Such thinking is not confined to management accounting situations or even financial situations. In politics, a common strategy to achieve a desired goal is to spend or commit as much money as possible at the beginning of a project. Then when people object, it is argued that the money already spent should not be wasted (hint: it has already been wasted – the money can’t be recovered!). A particularly bad example of the sunk cost fallacy in practice is the ‘Concorde effect’: the doomed joint project of the British and French governments with the supersonic commercial jet. While it was clear for over 30 years that continuing with the project would involve losing even more money, it was always continued because it was felt undesirable to waste the money already spent.
So, you can see failing to ignore sunk costs can have very serious consequences! Even though the consequences in management accounting are not usually as severe, be wary of letting them affect your decisions.
Stop and reflect
Think about the type of project which your organisation (or an organisation you are familiar with) might invest in. What would be the relevant costs and revenues that should be taken into consideration when deciding if the project should proceed?