Rethinking Sunk Costs—A Value Approach (includes associated papers 24402 and 24473 and 24476 and 24549 )
Authors: Capen E.C. 
Published: December 2007

As typically practiced in our business, most economic calculations lave out sunk costs. Integrated businesses can be hurt by the omission of sunk costs because profits and costs are not allocated properly among the various business segments. Not only can the traditional sunk-cost practice lead to predictably bad decisions, but a company that operates under such a policy will have no idea how to allocate resources among its operating components; amost none of its calculated returns will be correct. The solution is to include asset value as part of the investment in the calculation.

Introduction

There seems to be a wide gulf between the practice and the theory of handling sunk costs in typical oil-patch projects. The mythology of the sunk-cost concept says that you don't include money you've already spent in the economics of anything you may be doing in the future. For example, if you've already drilled a disappointing discovery, you wouldn't include the cost of the well to check the economics of completion. You test the revenues of the discovery only against the cost of the completion and any transportation or other facilities you might need. The cliché that seems to apply is, "Don't cry over spilled milk."

That simple view is appealing but not necessarily correct. Some textbooks take the position that the costs to be neglected are unrecoverable costs rather than all past costs. This principle seems to work well for the completion analysis mentioned above, because recovering the cost of a well that probably should not have been drilled could be very difficult. But who knows what a third party might see in such a well?

We nmight want to cast out the doctrine of sunk costs completely, because it's so easily misunderstood, and replace it with the principle of value.

For purposes of subsequent investment analyses, what you have spent has nothing to do with the problem, except perhaps as a tax write-off. What becomes important is what you could get for the asset under fair market conditions or how you value the asset internally.

Let's return to the simple example of the "wish-we'd-never-drilled-it" well. By comparing future cash-flow streams against just the completion and minimal facilities costs, we have left out a third and potentially important alternative: outright sale. You say, "But who would buy a virtually dry hole?" If it's worth something to you to go in and complete it, maybe it's worth even more to someone else to do the same thing. Maybe someone else knows how to operate low-productivity wells better than you do, so he or she can save on operating costs and pay you part of the savings. Or maybe he or she knows about a zone that eluded you and gives it some reasonable chance of producing. A person may just want to drill a very deep hole, and the hole makes a good start. Why the property is valuable to someone else isn't important; the important consideration is that, if your poor investment has value for someone else and you proceed with the completion anyway, you have foregone the income you could have obtained by selling. Therefore, count the value as investment.

There's nothing radical about this idea. Economists would recognize the principle and wonder why the oil industry doesn't practice it universally.

Phased Projects

Suppose that Myrtle has a two-phase project (Fig. 1) where spending on the first phase does not create an easily marketable entity. Thus, we needn't worry about the principle of market value.

Myrtle has to spend 100 screwbles and has a 50% chance of being on the successful branch requiring another expenditure of 100. She projects a value of 350 screwbles.

EquationHere, Ve=expected value,Vpp=present value of the project,Vpi=present value of the investment,and EI=investment efficiency.

In Myrtle's enlightened company, management ranks projects using investment efficiency (IE), finds that this project passes the test, and thus grants it acceptance. Management has imposed an IE hurdle of 0.1 rather than zero because it knows that not all the overhead costs are included in the calculations. It therefore must leave a little room for the additional spending.

Now what if the two phases of the project are separated not only by time but also by organization? That is, what if Myrtle successfully completed Phase 1 and the project has passed into a new group (Fig. 2)?