Main Street Finance

Is Sunk Cost a Sunk Theory?

By Jeff

I read an article recently, or more aptly, tens of articles recently, about how in today’s market regardless of if you are the CEO or the Janitor that you need to be adding incremental value. As an aside, interestingly enough, apparently 99% of authors are excused from the adding value requirement, because none of the articles I have read recently added any incremental value from the first.

Main St. & Incremental Value

The principle of basing decisions on marginal revenue and avoiding sunk cost is not a new concept, for sure, but this article got me thinking. This notion of adding incremental (marginal) value is something that residences of Main Street have know in theory, is key to any business decision. From the first economics class you ever take, it is drilled into you to think only of marginal value and to ignore sunk costs. That being the case, if you are anything like me, you probably think about that theory often.

But are you right in doing so? The answer, of course, depends on your personal opinion. If you were to ask me a few months, or even a few years ago, I would say forcefully, “yes”. However, my mindset may be shifting a little, and it started with an article I came across the Harvard Business Review by Clayton Christensen that gives a new spin on the old theory. Here is what Professor Christensen had to say:

“We’re taught in finance and economics that in evaluating alternative investments, we should ignore sunk and fixed costs, and instead base decisions on the marginal costs and marginal revenues that each alternative entails. We learn… that this doctrine biases companies to leverage what they have put in place to succeed in the past, instead of guiding them to create the capabilities they’ll need in the future. If we knew the future would be exactly the same as the past, that approach would be fine. But if the future’s different—and it almost always is—then it’s the wrong thing to do.” (Christensen, Harvard Business Review, July-August 2010)

When posed as Dr. Christensen mentions above, it shines a very new light on a very old theory, and makes one think about it a little. At least it did for me.

So, what do you think? Is the theory of sunk cost and marginal value antiquated, or are they classics that will stand the test of time?

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