Sunk cost vs opportunity cost

Often, organizations focus too much on sunken costs and ignore the opportunity costs associated with their decisions.

Since sunk costs are explicit and appear on financial statements, it makes sense that they are prioritized.

Often, opportunity costs go unnoticed because they are implicit and unconscious.

When making business decisions, it is often difficult to determine which costs to consider.

It is vital to understand sunk costs and opportunity costs and how they apply to your business.

Your business is more likely to succeed if you make smart decisions to save money and cut costs.

Business Costs

Almost every business incurs costs on a day-to-day basis. While some of these costs cannot be avoided, they can be reduced by identifying and reducing discretionary costs.

Centralized procurement software helps you keep track of both your direct and indirect costs, enabling you to streamline business processes and eliminate nonessential spending.

The first step to cutting costs is understanding them.

With an understanding of sunk costs and opportunity costs, managers can help businesses realize savings that meet their goals.

Companies can make educated business decisions based on understanding sunk costs and opportunity costs, minimizing costs, saving money, and ultimately setting themselves up for success.

What is a Sunk Cost?

Sunk Cost

A sunk cost is a cost that has already been incurred and cannot be recovered.

In terms of capital budgeting, sunk costs should not be considered because they have already occurred, regardless of the decision.

Sunk costs are easy to become entangled in, especially when they are explicit.

The explicit cost of running a business is the direct payment of wages and rent to others.

Costs that have already been incurred cannot be considered in future decision-making because they are sunk.

Business decisions must consider explicit costs, however, since they are direct costs to the company and could be avoided.

Sunk Cost Fallacy

Managers should be aware that the sunk cost fallacy can be a trap when considering sunk costs.

Our tendency to follow through on an endeavor if we have already invested time, effort or money into it, regardless of whether its current costs outweigh its benefits, is known as the Sunk Cost Fallacy.

In the decision-making process, economists warn us to avoid the trap of justifying a bad decision based on previous costs that no longer have relevance to the current decision.

Examples of Sunk Costs

In addition to salaries, depreciation and rental leases can be considered sunk costs.

Suppose your company built a state-of-the-art printer at a cost of $2 million.

If your buyers stop printing and decide to only publish their content online, then you are the one to blame.

Cost considerations must be made by your business. Depending on whether they decide to finish building the printer ($1 million), or to develop their online publication system ($2 million), they would either need to spend another $1 million or $2 million.

Depending on whether they decide to finish building the printer ($1 million), or to develop their online publication system ($2 million), they would either need to spend another $1 million or $2 million.

Sunk cost in this case is the $2 million already spent on building the printer.

We would be falling into the sunk cost fallacy if we continued to build the printer.Regardless of the $2 million already spent, it makes no sense to spend $1 million more on a printer you will never use.

Challenges with Sunk Costs

The key point to remember is that while sunk costs are all fixed costs, not all fixed costs are sunk costs.

By definition, sunk costs cannot be recovered. As a result, previously incurred costs can sometimes be sold for what they were originally purchased for.

Imagine that your company is considering stopping operations. In the event that they shut down, management must weigh the revenue they would lose against the costs they would eliminate.

Fixed costs such as factory leases and machinery have to be included as eliminated expenses in this case because the leases have a termination date and the machinery can be sold (accounting for depreciation).

Since these costs are now relevant, they will no longer be considered sunk costs.

It is also important to consider any variable costs that may be reduced by a particular decision.

What is Opportunity Cost?

Opportunity Cost

The Opportunity Cost refers to the loss of other alternatives when making a decision or not taking action.

Capital budgets often overlook opportunity costs because they are unseen, not included in financial reports, and are difficult to estimate.

Because Implicit Costs are considered, opportunity costs are often unseen.

Indirect costs are those that have occurred but are not necessarily shown as separate expenses.

Implicit costs are more difficult to quantify because they are often non-quantitative.

Investment decisions can be made more intelligently if managers are aware of trade-offs.

In order to estimate opportunity costs correctly, all other potential alternatives must be weighed against each other.

Examples of Opportunity Costs

Let’s say you have to decide whether you should invest in the stock market to earn returns or reinvest in your company.

According to historical data, the average stock market return is 10%.

You have been told by a manager at your company that investing back into the business will have a 8% return.

Calculate opportunity cost by using the following formula:

A company’s opportunity cost is equal to the return on the most profitable forgone option minus the return on the chosen option

Investments back into the company would result in an opportunity cost of (10%-8%), which equals 2% of lost profits.

As a result, should your company decide to reinvest in the business, they will sacrifice higher profitability.

Challenges with Opportunity Cost

One of the main challenges with opportunity costs is the difficulty in calculating them accurately.

The return on investment is often an estimate rather than a hard number.

In addition, non-monetary factors like risk, time, skill, and effort can be difficult to define.

This is not to say trade-offs should not be estimated and taken into account when making business decisions, but rather that only after each investment decision has been made can managers compare them.

Similar to opportunity costs, implicit costs are difficult to estimate as well.

If you choose one alternative over another, you may sacrifice energy, time, or even happiness, all of which cannot be quantified.

Consider finding a new job, for example. It pays well, but requires long hours and is not a role you would enjoy.

On the other hand, Job B will bring you more satisfaction, with shorter hours and a lower salary.

In comparing the salaries between the two jobs, we can easily find the opportunity costs.

With fewer working hours, it is much harder to determine the levels of happiness you will experience or what you can accomplish with the extra time.

Moreover, when the returns may occur in different forms or at different times, comparing opportunity costs becomes more difficult.

A business may be choosing between two investment options. Choosing Option A will net the company $2 million, but will tie up the company’s cash for two years.

A return of $10 million is possible with Option B, but the company’s cash would be locked up for 7 years.

Due to the urgency of liquid assets and the importance of the timeline of returns in this case, opportunity cost is part of the opportunity cost.

Liquidity is not available if money is tied up for a longer period of time, even though higher returns are generated.

What’s the Difference between Sunk Costs and Opportunity Costs?

Meaning

• As a result of incurred costs, sunk costs cannot be recouped.
• means that opportunity costs represent missed opportunities.

Implicit or Explicit

• Cash flows determine sunk costs, so they are explicit
• As they are notional in nature, opportunity costs are generally implicit and are not based on cash flows

Estimation of Cost

• Since they are based on actual purchase prices that have been incurred, sunk costs can be estimated accurately.
• Due to the fact that opportunity costs tend to be notional and their value is a little more subjective, they are harder to estimate.

Reporting

• In the balance sheet and financial statements, sunk costs are reflected.
• Financial reports do not include opportunity costs, though managerial reports may include them.

Role in Decision Making

• In a business decision, sunk costs are no longer relevant since they have already been incurred.
• In making future business decisions, opportunity costs are critical since they represent the potential benefits that a business loses when choosing one alternative over another.

How can Considering these Costs Improve how your Company Does Business?

Businesses always want to save money, and understanding sunk as well as opportunity costs will allow them to do just that.

Controlling business costs allows identified savings to match realized savings.

Cost management involves establishing a budget, estimating costs, and then managing these costs throughout the project or investment.

Analyze the following scenario and learn how considering sunk and opportunity costs can help you improve your decisions and how you do business.

Suppose your company spent $50,000 training its employees on how to use a new CRM system.

The employees have yet to fully grasp the new system after a year of training.

By switching to an alternative training program costing $30k, your procurement department has identified an opportunity to save 40% over the next fiscal year.

There are some managers in your company who are hesitant to switch because they invested $50,000 in a training program and should just continue with it.

Sunk costs are explained to them by your newest manager, who is familiar with sunk costs.

In spite of the $50,000 investment, continuing with the training would be a poor business decision.

In addition to being more expensive, sticking with the current program would also mean sacrificing the higher-quality training provided by the new system.

In the end, switching to the new CRM training system is the better business choice.

With a deep understanding of both sunk costs and opportunity costs, managers will be able to accurately estimate the costs associated with potential investments and projects and identify the best course of action to take, ultimately saving your business money and making it more profitable.

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