Sunk Cost Vs Opportunity Cost: What's The Difference? | PLANERGY Software - Deepstash

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What is a Sunk Cost?

What is a Sunk Cost?

A sunk cost refers to a cost that has already occurred and has no potential for recovery in the future. Given that sunk costs have already occurred, the cost will remain the same regardless of the outcome of a decision, and so they should not be considered in capital budgeting.

It is easy to get hung up on sunk costs, especially when they are explicit costs. Explicit costs are direct payments made to others in the course of running a business, such as wages, rent, and, materials.

  • Explicit costs which have already been incurred are sunk and are irrelevant to future decision-making.
  • Explicit costs which will occur in the future, however, are relevant to business decisions as they will be direct costs to the company that could be avoided.

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Sunk Cost Fallacy

One trap managers should be aware of when it comes to sunk costs is the sunk cost fallacy. The Sunk Cost Fallacy describes our tendency to follow through on an endeavor if we have already invested time, effort, or money into it, whether or not the current costs outweigh the benefits.

Economists tell us we should avoid falling into this trap in the decision-making process that justifies a bad decision based on previously incurred costs that no longer bear relevance to the decision at hand.

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Challenges with Sunk Costs

It is important to note that while all sunk costs are fixed costs, not all fixed costs are sunk costs. 

Sunk costs are, by definition, those which cannot be recovered by any means. Some previously incurred costs can be sold on for their purchase price and therefore are not considered sunk.

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What is Opportunity Cost?

An Opportunity Cost is the loss of other alternatives when one option is chosen or no action is taken. Opportunity costs are unseen, not included in financial reports, and can often be forgotten about in capital budgeting. Part of the reason opportunity costs are unseen is because they consider Implicit Costs.

An implicit cost is any cost that has already occurred but is not necessarily shown or reported as a separate expense. These costs are much harder to measure as they are not always quantitative. Being aware of trade-offs will allow managers to make better-educated investment decisions.

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Challenges with Opportunity Cost

The main challenge with opportunity costs is that they are hard to accurately calculate. Returns on investments are often estimated rather than hard-set figures.

It is also not always easy to define non-monetary factors like risk, time, skills, or effort. This is not to say trade-offs should not be estimated and considered in business decision-making, but rather that it is only after a choice has been made that managers will have the hindsight to see how each investment decision is compared.

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The Difference between Sunk Costs and Opportunity Costs: Meaning and Estimations

Meaning

  • Sunk costs have already been incurred and cannot be recovered by any means
  • Opportunity costs represent forgone returns of alternative opportunities

Implicit or Explicit

  • Sunk costs are explicit as they are the result of actual cash flows
  • Opportunity costs are generally implicit as they are notional in nature and do not come in the form of cash outflow

Estimation of Cost

  • Sunk costs can be accurately estimated as they have actual purchase prices that have been incurred
  • Opportunity costs are harder to estimate as they are often notional and their value is more subjective.

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The Difference between Sunk Costs and Opportunity Costs: Reporting and Role in Decision Making

Reporting

  • Sunk costs have already been paid for and are reflected on balance sheets and financial statements
  • Opportunity costs are not shown on financial statements, though they may be included in managerial reports

Role in Decision Making

  • Sunk costs have already been incurred and are therefore no longer relevant to future business decisions
  • Opportunity costs are very important to future business decision-making as they represent the potential benefits a business misses out on when choosing one alternative over another.

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CURATED BY

geoporter

Firefighter

Sunk Costs are explicit and appear on financial statements so it is understandable why these costs are honed in on. Opportunity Costs are implicit and unseen, so they are often overlooked.

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