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Sunk Costs
Sunk costs are expenses that have already been paid or have already been committed to. Past research
and development is an example. Since sunk costs are not incremental to the proposed project, NPV
analysis must ignore them. NPV analysis is always forward-looking. The past cannot be changed and
so should not enter into the choice of a future course of action. If research was undertaken last year,
the effects of that research might bear on future cash flows, but the cost of that research is already
water under the bridge and so is not relevant in the decision to continue the project. The project
decision must be made on the basis of whether the project increases or decreases wealth from the
present into the future. The past is irrelevant.
Overhead
The treatment of overhead often gives project managers a headache. Overhead comprises expenditures
made by the firm for resources that are shared by many projects or departments. Heat and maintenance
for common facilities is an example. Management resources and shared support staff are other
examples. Overhead represents resources required for the firm to provide an environment in which
projects can be undertaken.
Different firms use different formulas for charging overhead expenses to various projects and
departments. If overhead charges accurately reflect the shared resources used by a project, then they
should be treated as incremental costs of operating the project. If the project were not undertaken,
those shared resources would benefit another moneymaking project, or perhaps the firm could
possibly cut some of the shared overhead expenditures. Thus, to the extent that overhead does
represent resources used by the project, it should be included in calculating incremental cash flows. If,
on the other hand, overhead expense is unaffected by the decision to undertake the new project, and no
other proposed project could use those shared resources, then overhead should be ignored in the NPV
analysis.
Sometimes the formulas used to calculate overhead for budgeting purposes are unrealistic and
overcharge projects for their use of shared resources. If the financial analyst does not correct this
unrepresentative allocation of costs, some worthwhile projects might incorrectly appear undesirable.
Computing NPV: The Time Value of Money
In deciding whether a project is worthwhile, one needs to know more than whether it will make
money. One must also know when it will make money. Time is money! Project decisions involve cash
flows spread out over several periods. As we shall see, cash flows in different periods are distinct
products in the financial marketplace—as different as apples and oranges. To make decisions affecting
many future periods, we must know how to convert the different periods‟ cash flows into a common
currency.