An embedded cost is an expense a company has already incurred as part of a project, and has no hope of recovering. The money in this case has already been spent. These costs can play an important role in financial planning activities, where understanding expenses can be important for decision makers. They can also contribute to mistakes when it comes to financial decisions that are not carefully thought through.
Also known as a sunk cost, such expenses can arise in the operation of numerous businesses. At the time the money is spent, the company may qualify for special tax treatment, as it is making an investment in its operations with the money. It may be able to claim deductions or direct tax credits for an embedded cost, depending on the nature of the expenses and the tax code in a given year. Each embedded cost must be carefully tracked and accounted for in order to qualify for benefits.
One area where embedded costs can become a problem is in decision making where people want returns on investments. They may factor the costs into the operating expenses, without considering that the money has already been spent. For example, a landlord who owns a property free and clear might consider the price paid when charging monthly rents, along with expenses like electricity, cleaning services, and so forth. When rent prices drop, landlords may believe that they should stop renting, waiting for prices to rise again, but in fact, anything that exceeds the monthly expenses is a return on the investment because the embedded cost was already incurred.
If the hypothetical landlord doesn’t rent the property at all, it will still be necessary to pay all the monthly utility costs, and the landlord won’t have a chance of recouping the initial investment. Renting at a reduced rate, however, can allow the landlord to cover these monthly costs and start to apply earnings to the property. It is important to separate an embedded cost already paid for from ongoing expenses when making decisions about how to use assets and investments.
Such costs can also create a liquidity issue. This can be a problem if companies overstretch themselves in initial costs, because they may not have funds for emergencies. A hotel, for example, cannot sell its primary facility to cover expenses without going out of business. Likewise, an investor might have to abandon a position to access funds, but then wouldn’t have a chance of making returns.