I will be discussing the concepts of these costs and how they can hurt innovation.
Fixed/Sunk Costs (Blog 4)
Fixed and sunk costs dive deeper into configuring a DCF model and getting cash flows. Cash flows are benefits minus costs. There are several different costs that go into a decision, so valuating them the right way in crucial. Fixed costs are costs whose level is independent of the level of output, like salaries, insurance and taxes. (In contrast, examples of variable costs are sale commissions, cost of raw materials and utility costs.) Sunk costs are those portions of fixed costs that has already been spent and which cannot be recovered. Some examples include initial R&D costs, investments in buildings and capital equipment.
While suck costs are important, they are not included in future cash flows. Since sunk costs are usually paid at or before time 0 and aren’t reoccurring, they aren’t included in finding cash flows. Total costs are found by adding variable and fixed costs. You then subtract total costs from benefits to get cash flows in a DCF model
The problems with Sunk Costs fit into these 2 axioms:
1. “To make money you have to spend money”
2. “Throwing good money after bad”
As mentioned above, Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision. This is a problem for the 2 scenarios mentioned above.
When Sunk Costs are included in valuating decisions, they often cause the valuation to look less attractive. For instance, a cost at time 0 of $0 will portray a prettier picture in an NPV analysis than a cost of $100,000. This is because there is little to no benefit to balance the cost with at time 0. Therefore, many companies choose to not account for sunk costs in valuations or they simply do not invest. This is where the famous mantra “To make money you have to spend money” comes into play.
In the second scenario of sunk costs, companies will avoid having to pay and account for new innovations by dumping more money into existing technologies. For instance, using cheaper/older technologies may reflect well in your early profits but could hurt companies in the long run when competitors are ahead in innovating. “Throwing good money after bad” refers to spending more money on something problematic that one has already spent money on, in the hopes of fixing it or recouping one’s original investment. These are both common problems decision makers make when dealing with sunk cost.