In cost accounting, there are specific costs related to planning and decision making of business activities. In this article,the definitions of sunk cost and opportunity cost, methods of calculating sunk cost and opportunity cost, the purpose of sunk cost and opportunity cost calculations, and finally, the difference between sunk cost and opportunity cost are explained in detail.
What is Sunk Cost?
Sunk cost or unavoidable cost refers to the unrecoverable cost that has been already incurred in the past. These costs have been incurred due to certain decisions made in the past. In the organizational perspective, examples of sunk costs include the net book values of the company ownedassets such as property, plant and equipment, investments, inventories, etc.
For example, if a company purchases a building worth $ 100,000 that has a scrap value of $ 5,000 , then the sunk cost would be $ 95,000 i.e. the difference between the initial price and the scrap value. Through these types of investments, gains or losses can be achieved only at the time of disposing of the assets. Therefore, the losses or gains are entered in financial statements that are prepared at the end of the financial period.
What is Opportunity Cost?
According to John Perrow, opportunity cost refers to the amount of the next best product that can be produced instead of the current product that is manufactured. Simply, opportunity cost is the value of the next best alternative forgone. For example, if a company is investing capital on buying equipments and inventories, it would not be able to invest on buying shares and debentures that would earn interest and dividends. The loss of interest and dividends with the selection of the first option is known as the opportunity cost.
Opportunity cost can be used for various factors like determining the relative prices of goods that are manufactured, in order to allocate the company resources effectively and efficiently and also to make cost comparisons, etc. Although the opportunity cost is not entered in accounting records, it is an essential factor to be considered when making important decisions.
What is the difference Between Sunk Cost and Opportunity Cost?
The major difference between sunk cost and opportunity cost is that when the organizations are making important strategic decisions for their future, sunk cost must not be considered as it incurred in the past and cannot be recovered. However,the opportunity cost would be useful in deciding the best option that must be selected in making important decisions.
In conclusion, it can be said that both these costs relate to business planning, and especially opportunity cost can be useful for making crucial decisions on behalf of the organization.
Photo By: Dustin Moore (CC By 2.0)
Further Reading:
- Difference Between Sunk Cost and Relevant Cost
- Difference Between Fixed Cost and Sunk Cost
- Difference Between Opportunity Cost and Marginal Cost
- Difference Between Opportunity Cost and Trade Off