Sunk Costs and Expected Returns

Sunk Cost Expected ReturnSunk costs and expected returns are two subjects that come up quite often in business. They’re also two subjects that are frequently analyzed inaccurately.

Sunk costs relate to unrecoverable costs that have been invested in a project. They may have value and may still provide a return. But the mistake that business people can make is to become too emotionally attached to those sunk costs and not accurately consider optional projects for future investment because they think they should take advantage of their previous investment.

Expected returns are sometimes less obvious to analyze because probabilities about future outcomes can be difficult to quantify.

Here’s an example of these two subjects in a test question from a Microsoft Sales Specialist Assessment test:

Sunk Costs Expected Returns

This question really has just one correct answer. Which do you think it is?

Let’s analyze the possible answers:

Answer A – It is true that Prospect A has a higher probability of closing, but you need to analyze the expected return. You need to consider the dollar value of the sale and the probability of closing.

Answer B – This is the sunk costs issue. The sales person and his manager might be emotionally attached to all the effort they’ve invested in prospect A. But it’s all unrecoverable costs. The only accurate way to evaluate the two opportunities is to consider future costs and forget past costs. The investments of the past mean nothing.

Answer C – This is a pure expected return issue. Which opportunity has the highest expected return? Expected return is simply calculated as (the probability of closing) x (the value of the opportunity).

Answer D – You may have to spend more time to close Prospect A. It doesn’ t matter what you’ve already spent. When comparing this opportunity to the other does it make more sense to invest additional time and money in Prospect A or Prospect B?

The correct answer is C. The expected return of Prospect B is greater than the expected return of Prospect A.

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