Business entities incur all kinds of costs during the course of their operations. The incurrence of these costs while necessary to run the business, do reduce the profitability of the entity. Budgeting for costs thus assumes utmost importance for the management of any entity. Costs may be explicit i.e., requiring actual payout or implicit i.e., notional in nature. Both these costs are equally important and understanding their nature and what affects them is an important precursor to budgeting.
This article looks at meaning of and differences between two types of such costs – opportunity cost and sunk cost.
Definitions and meanings
Opportunity cost is the potential profit or gain that is lost out on when an entity opts for one alternative over another. Essentially opportunity cost is the cost of decision making. When business entities are faced with decisions, there may often be several alternatives to choose from. Each alternative comes with its own set of incomes and expenses. In the bargain of choosing one alternative over the other, the entity loses out on the profit potential of the alternative foregone – this is the opportunity cost of choosing the selected alternative.
ABC Inc owns a large piece of industrial land. Currently, ABC Inc. earns an annual rent of $100,000 from leasing out this land. ABC Inc. is now considering a proposal of building a bottling plant on this industrial land.
Once this land is used for the bottling plant, it will no longer earn the rent that it currently receives. Thus, while doing a cost-benefit analysis of the proposition of putting up the bottling plant, ABC Inc. must also consider the opportunity cost of foregoing the rental from the land.
Primarily this means that the bottling plant must earn a revenue of at least $1,00,000 to recoup the opportunity cost.
Opportunity cost is an implicit cost as it does not result in any actual cash outflow for the entity. It is thus not accounted for nor does it reflect in any financial statements. It, however, may find its way into management reports that reflect the rationale for management decision making.
Sunk cost represents those costs that have already been incurred by the entity and cannot be recouped. As sunk costs relate to an action that has already taken place, they are past costs and thus their analysis has no place in decision making. Identifying sunk costs is important because management must distinguish between these costs and potential future costs that are to be evaluated for decision making.
When taking any decision, sunk costs already incurred must have no bearing on the future decision making.
ABC Inc. is considering launching one of two new product lines. To gauge the depth of their marketability, it hires a marketing firm to carry out an extensive public survey. The cost of conducting this survey is $50,000. The result of the survey elaborates the likely cash flows that can be generated from sale of both the product lines. While choosing between the two product lines, ABC Inc. must ignore the cash outflow of $50,000 being the cost of conducting the survey. As this cost has already been incurred, it will remain so irrespective of the product line chosen or irrespective of whether ABC Inc. even chooses to launch any new product line at all.
Sunk costs are actual out-of-pocket expenses and are thus explicit costs.
Difference between opportunity cost and sunk cost
The seven important points of difference between opportunity cost and sunk cost are detailed below:
- Opportunity cost is the cost of a missed opportunity i.e.: the profit/gain foregone when choosing one business alternative over another.
- Sunk cost represents past costs that have already been incurred and cannot be recovered.
2. Notional v/s Actual
- Opportunity costs are implicit costs as they are notional in nature and do not result in actual cash outflow for the entity.
- Sunk costs are explicit costs as they result in actual cash outflow for the entity.
3. Estimation of cost
- The estimation of opportunity cost can be subjective. For example, while calculating the loss of profit while evaluating alternatives, there may be some degree of subjectivity involved in estimating the potential loss of profit.
- The calculation of sunk cost is completely objective with no requirement for estimation as these are actual costs already incurred.
- Opportunity costs are notional costs and thus not accounted for.
- Sunk costs are actual costs and hence accounted for in the books as well as reported in the financial statements.
5. Role in decision making
- Evaluation and analysis of opportunity costs plays a very important role in decision making. These costs are used for cost comparison while undertaking capital budgeting.
- Sunk costs do not have any role in decision making as they are past costs. Although these result in cash outflow they do not find place in NPV or IRR calculation as these capital budgeting techniques consider only future costs.
- Opportunity costs are not reported in financial statements but may be reported in internal management reports.
- Sunk costs are reported in the published financial statements.
- Examples of opportunity cost include – loss of rent when the same land is used for other purposes, loss of productive time of workers when sent for training etc.
- Examples of sunk costs include – conducting marketing studies to evaluate feasibility, R&D cost for developing new product etc.
Conclusion – opportunity cost vs sunk cost:
While opportunity cost and sunk costs play distinctively different roles in decision making process, they both may be unavoidable to some extent. Opportunity costs are likely to occur as it may not be possible for an entity to choose both alternatives, hence, some sacrifice will be required. Similarly sunk costs may necessarily be incurred before reaching the stage of decision making. For example, marketing costs or R&D costs must be incurred before an entity can even consider launching new products.