Question

• Why is it that sunk costs are never relevant to a decision whereas opportunity costs are always relevant?
• Why do you think Goldratt’s Theory of Constraints received so much press by the business community?  

Answer 1

Sunk costs are the cost which is incurred in past and do not play a role in decision making. For example, book value of old equipment, depreciation of old equipment, cost of inventory, etc

Opportunity cost is the cost of forgoing an alternative course of action. Hence it becomes relevant in decision making since one alternative is pursued and cost of another alternative not pursued becomes a cost in evaluation. Hence it is called opportunity cost. For example making production and not giving a warehouse on rent will have opportunity cost of rent forgone.

In short, cost incurred in past are irrelevant cost in decision making and cost difference between two alternatives are relevant cost in evaluation

The Theory of Constraints helps in identifying the limiting factors that is constraints or bottlenecks. Once management has identified the limiting factors then management can accordingly allocate the constraint resource in best possible way to ensure the resources are utilised to get maximised returns. Limiting factors in an organization can be any resource for example, labour hours or machine hours. The theory of constraints helps in developing plan based on constraint resource and achieving most profitable mix.

Theory of constraints can lead to following benefits:

· Increase in profit

· Improved utilisation of capacity

· Reduction in inventory levels

· Reduced lead times for sourcing of materials.