Question

WEEK 5: RELEVANT COSTS

What is an example of an opportunity cost? How about a sunk cost? Are either of these relevant? Avoidable? Examples from work would be great!

Answer 1

Sunk costs: Sunk costs are costs that were incurred in the past. These are irrelevant for decisions, because they cannot be changed. Thus are not to be taken into account while making management decision because no action can reverse them.

Example: For example, a business purchased a machine several years ago. Due to change in trend in several years, the products produced by the machine cannot be sold to buyers. Thus the machine is now useless or obsolete. Now the price originally paid to purchase the machine cannot be recovered by any action and will be termed as a sunk cost.

　

Opportunity cost: Opportunity costs are the profit foregone by selecting one alternative over another. It refers to the net return that could be realized if a resource were put to its next best use. Although is not entered in the accounting records however must be considered while making decisions because they shows the foregone profit that could have been elsewhere

Example: For example, in a given time frame such as a day or month, a machine can run only so many hours, it can do production only so many units, and an employee can work only so many hours. The appropriate way for decision analysis whether to accept a new client or sales order, or doing production of a new type of product would be depending fundamentally on whether the company has the capacity to service the new client, fill the sales order, or make the new product, without displacing existing customers, orders or products. In case the new client, sales order, or product can be accommodated without displacing existing clients, orders or products, the business can be termed as having sufficient excess capacity, conversely if the new client, sales order or product will displace existing clients, orders or products, the organization can be termed as having a capacity constraint. If the firm has a capacity constraint, then the decision of whether to accept the new client or order, or making production the new product, should consider the opportunity cost of clients, orders or products that will be displaced. If the business has excess capacity, the decision is typically simpler: there is no opportunity cost arising from a capacity constraint, thus the correct decision depends only on the marginal revenues and costs from the new client, order or product.