Question

Differentiate between opportunity costs and sunk costs. Are they used differently in decision-making? Explain.

Answer 1

Solution

Sunk costs are the costs that you have already incurred. This is the money that you have put into some particular endeavor and which you can not recoup. For example, if you buy machinery to produce a certain product, the price of that machinery is sunk. You have already paid for it and cannot get that money back. The concept of sunk costs is important because people should not let sunk costs influence them. You must not look back at the money you spent on that machinery and say "I have to keep going with this project because I've already spent this money." Instead, you must only look forward at whether you can make money in the future with that project.

By contrast, opportunity cost is something that people must take into account. An opportunity cost is the value of a forgone activity or alternative when another item or activity is chosen.

Let's say you own a piece of land and you can build a house or an office building there. If you choose to build the house, the opportunity cost is the money you could have made by renting the office building to others.

Opportunity costs must be considered when making decisions. Understanding the potential missed opportunities foregone by choosing one investment over another allows for better decision-making. Considering the value of opportunity costs can guide individuals and organizations to more profitable decision-making.

When making big decisions like buying a home or starting a business, you will probably scrupulously research the pros and cons of your financial decision, but most day-to-day choices aren't made with a full understanding of the potential opportunity costs. If they're cautious about a purchase, many people just look at their savings account and check their balance before spending money. Often, people don't think about the things they must give up when they make those decisions.

The problem comes up when you never look at what else you could do with your money or buy things without considering the lost opportunities. Having takeout for lunch occasionally can be a wise decision, especially if it gets you out of the office for a much-needed break.

However, buying one cheeseburger every day for the next 25 years could lead to several missed opportunities. Aside from the missed opportunity for better health, spending that $4.50 on a burger could add up to just over $52,000 in that time frame, assuming a very achievable 5% rate of return.

This is a simple example, but the core message holds true for a variety of situations. It may sound like overkill to think about opportunity costs every time you want to buy a candy bar or go on vacation. Even clipping coupons versus going to the supermarket empty-handed is an example of an opportunity cost unless the time used to clip coupons is better spent working in a more profitable venture than the savings promised by the coupons. Opportunity costs are everywhere and occur with every decision made, big or small.

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