Sunk Costs vs. Externalities: Key Differences in Project Evaluation

Imagine you are thinking about opening a new coffee shop. You spend time researching locations, developing a menu, and even paying for some initial architectural sketches. At this stage, you are evaluating if this new coffee shop is a good idea. During this evaluation, you need to consider different types of costs and impacts, and it’s crucial to distinguish between two important concepts: sunk costs and externalities like cannibalization.

Let’s first talk about sunk costs. Think about those architectural sketches you already paid for. Let’s say you spent a few hundred dollars on them. Now, you are reconsidering the entire coffee shop project. Perhaps you found a location that is not as ideal as you initially thought, or maybe your market research suggests less demand than you hoped. The money you spent on the sketches, that is a sunk cost. It’s money that has already been spent, and importantly, you cannot get it back regardless of whether you proceed with the coffee shop or not. It’s gone.

Sunk costs are past costs that are irretrievable. They are expenses that have already been incurred and cannot be recovered no matter what future decision you make. Other examples could be the time you spent researching, or perhaps a non-refundable deposit you paid on a potential location. The key thing about sunk costs is that they should be irrelevant when you are making decisions about the future. Why? Because your decision about whether to open the coffee shop now should be based on the potential future revenues and future costs, not on money already spent and gone. It’s like crying over spilled milk; the milk is gone, and focusing on it won’t bring it back or help you decide what to do next. In project evaluation, we must consciously ignore sunk costs to make rational decisions about whether to continue, modify, or abandon a project.

Now, let’s consider cannibalization, an externality. Imagine you already own a successful bakery in town, and you are thinking about opening that new coffee shop. If you open the coffee shop, it’s likely that some of the customers who currently buy pastries from your bakery might decide to get their morning coffee and pastry at your new coffee shop instead. This shift in customer spending from your bakery to your coffee shop is cannibalization. It’s a negative externality, specifically a negative internal externality, because the negative impact is felt within your own business portfolio.

An externality, in general, is an impact of a project on something or someone else that is not directly involved in the project. It can be positive or negative. For example, if your coffee shop brings more foot traffic to the area, and that benefits other nearby businesses, that would be a positive externality. Cannibalization is a specific type of negative externality where a new project reduces the profits or success of an existing project, especially within the same organization. It’s like one part of your business eating into the market share or revenue of another part.

The crucial difference between sunk costs and cannibalization is their nature and their relevance to decision-making. Sunk costs are about the past and are irrelevant to future decisions. They are already spent and gone. Cannibalization, on the other hand, is about the future and is highly relevant to project evaluation. It’s a potential future consequence of undertaking a new project that needs to be carefully considered. When evaluating the coffee shop, you need to estimate how much revenue it will generate, but also how much revenue it might take away from your existing bakery. This reduction in bakery revenue due to the coffee shop is the cannibalization effect, and it directly impacts the overall profitability of your business portfolio.

In project evaluation, we ignore sunk costs because dwelling on past, unrecoverable expenses can cloud our judgment about the future. We focus on future cash flows and potential profitability going forward. Conversely, we must carefully consider externalities like cannibalization because they represent real future impacts, often negative, that will affect the overall success and financial viability of our projects and businesses. Ignoring cannibalization can lead to an overestimation of the benefits of a new project and ultimately poor investment decisions. By understanding the distinction, you can make wiser, more informed decisions about your coffee shop, or any project you might be evaluating.