In the world of business, costs are an inevitable part of everyday operations. While minimizing costs is a key objective, it's essential to recognize that not all costs are created equal. Some costs have the potential to help organizations turn a profit, give them vital industry insights that boost profitability, foster innovation, and lead to profitability. Today let's talk about two such costs we speak about in industry, sunk cost and opportunity cost.
Sunk costs are out-of-pocket expenses that can never be recovered. Businesses may need to deploy resources more efficiently and make wiser financial decisions when they understand the nature and importance of these factors. No matter what decisions or acts we make in the future, sunk costs cannot be recovered. They comprise of prior project investments, advertising, market research, installation costs, development, and extra inventory. Future choices shouldn't be influenced by these expenses, and businesses shouldn't be forced to follow them.Opportunity cost is the value or benefit that is lost or sacrificed when one choice is chosen over an alternative. It stands for the potential advantage or return that may have been realized by choosing the optimal alternative instead of the chosen one. In other words, it calculates the cost of not selecting the second-best course of action. When determining opportunity cost, one must contrast the returns or benefits of the best option foregone (FO) with those of the option chosen (CO). The opportunity cost is calculated by deducting the chosen option's return from the best forgone option's return.
Opportunity cost = return on best foregone option (FO) – return on chosen option (CO)
In short, an investment or expense that a business has already made in the past is in fact a sunk cost. It is a one-time cost that cannot be recouped. Sunk costs are not taken into account in capital planning or decision-making since they are irrevocable and unchangeable. Opportunity costs, on the other hand, represent forecasts of potential future earnings based on various investment possibilities. They stand in for the advantages that might be gained by selecting one choice over another. Opportunity costs are an evaluation of the benefits sacrificed when choosing one alternative over another rather than real expenses or payments.
Making wise financial decisions requires knowing the difference between opportunity costs and sunk expenses. Sunk costs are past expenditures that shouldn't affect decisions made in the future, whereas opportunity costs are the potential benefits that could be realized by choosing the optimal alternative.