When companies are performing capital budgeting, they must consider various costs related to the projects. Mostly, these include costs directly associated with the project, such as material and labour. However, it may also consist of some other costs, which may not be as clear. These usually include opportunity and sunk costs. There are some differences between both.
What are Sunk Costs?
A sunk cost represents money that a company or business has already spent. While in finance, any cost is relevant, in decision-making sunk costs are irrelevant. It is because it represents money spent that the company cannot recover. Similarly, since the company has already paid for it, it does not alter the decisions that a company makes.
Sunk costs are in the past and vary from future costs. Therefore, they do not contribute to a company’s decisions. Companies usually exclude sunk costs from their decision-making due to this reason. Therefore, identifying sunk costs and differentiating them from others is crucial in decision-making. For companies, sunk costs do not represent relevant costs.
For example, a company may have to decide on either using in-house production or outsourcing. If it chooses to use in-house production, it may use its factory building that it has already acquired for $100,000. In that case, the company can make $200,000 from the project. In case it chooses to outsource, it can make a profit of $150,000.
Some may think that the second option provides a better return as the company can make $150,000. On the other hand, they may believe the first decision will only make $100,000. It is because it involves using the $100,000 factory, which reduces the benefits of in-house production. However, the factory cost in that example is a sunk cost.
Therefore, the $200,000 profit that inhouse production brings does not include any other costs. Since the factory cost of $100,000 is irrelevant to the decision, it does not reduce the profit. If the company could recover the $100,000 factory cost with either decision, it would be relevant to the decision-making process.
Overall, sunk costs do not impact the decision-making process. They remain unchanged and do not have any future impact. Therefore, companies ignore sunk costs when measuring their profits from projects or investments.
What are Opportunity Costs?
Unlike sunk costs, opportunity costs are relevant to the decision-making process. Therefore, companies must calculate these and include them when measuring profits from various projects. However, opportunity costs are not actual costs that companies bear. These represent the profits or benefits that companies miss out on when choosing one course over another.
Opportunity costs represent the value that decision-makers lose when choosing between various options. While a single project may have sunk costs, it will never have opportunity costs. It is because the company does not have to choose between two projects. Essentially, whenever companies have to choose between various decisions, they will suffer opportunity costs.
For example, a company may choose to invest in a project that provides $100,000 in profits. However, the company must take the resources out of from an existing project that can profit $20,000 in the future. In this decision, the $20,000 relinquished in choosing the first project represents an opportunity cost.
Conclusion
When making decisions, it is crucial for companies to identify relevant costs. Sometimes, however, these costs may not be as clear, like sunk and opportunity costs. Sunk costs represent any money that a company has already spent in is not recoverable. On the other hand, opportunity costs refer to the profits foregone when choosing between several options.
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