Opportunity costs represent a foregone opportunity for an investor or entity when choosing one option over the other. It is a widely used concept in the capital budgeting method when deciding between mutually exclusive projects.
Sunk costs represent a type of non-relevant costs that cannot be recovered and already spent.
Investment decisions mainly focus on future and incremental cash flows. Thus, sunk costs do not affect such decisions directly.
Let us evaluate some key differences between opportunity costs and sunk costs.
The opportunity cost is the value of a foregone opportunity when choosing one option over the other. Simply, it is the benefit that could have been received if not chosen for the other option.
Opportunity costs are never incurred or paid by the individual or an entity. Since these costs are never incurred nor seen, these are often overlooked by decision-makers.
Opportunity cost can be calculated as:
Opportunity Cost = Return on FO – Return on CO
Where FO = Foregone Option and CO = Chosen option.
The return on both options can be calculated by the NPV formula.
NPV = FCF + FCF1/(1+r)1 + FCF2/(1+r)2 + …. FCFn/(1+r)n
Example of Opportunity Costs
Suppose a company ABC has a mineral extraction contract from a land. The company estimates the total revenue of $ 5,000 million (NPV terms) if they take the project. The company would need to invest $ 1,000 million to generate that profit.
ABC can sell the land for $ 3,500 outright as well.
The accounting profit for ABC is $ 4,000 million if they operate the project. However, by choosing that option, they have foregone an opportunity of $ 3,500 of selling the land. Thus, economically, the company has generated a profit of only $ 500 million.
In other words, the company had an opportunity cost of $ 3,500 million to generate a profit of $ 4,000 million.
Important Considerations with Opportunity Costs
The concept of opportunity cost is only relevant where an alternative is available. For instance, in our example above, if the company ABC is the only company with mineral extracting rights over the land, then no other company would buy that land. Thus, there will be no opportunity cost.
Opportunity costs are important for mutually exclusive investment options. The investor should always invest in the highest NPV investment. However, the investor will always forfeit some opportunity cost by choosing one option over the other.
Sometimes an entity may be indifferent between investments. However, it cannot commit funds segregated for loan payments or any other inevitable costs. Thus, such situations do not present an opportunity cost practically.
Also, both the investment opportunity and the opportunity cost present a future prediction. It means returns from both options are uncertain. Thus, the practical evaluation for both options is always skeptical.
Sunk costs are already incurred and cannot be recovered. This cost is a type of non-relevant cost in the decision-making process for investment appraisals.
A company may evaluate several investment options. For example, choosing between two or more products to launch. The company would first spend money on research and development for these products.
Regardless of the choice to produce one product over other, the money spent on research and development cannot be recovered now. Thus, that cost is considered a sunk cost. Hence, the sunk cost does not affect the decision here.
Common Examples of Sunk Costs
Suppose a company ABC manufactures luxury watches in Europe. It wants to expand the market share to Asia. The company conducts research and prepares a feasibility report to expand internationally to a new region.
Suppose ABC spends $ 10 million on the research project. Now, regardless of the choice ABC company makes, the spent $ 10 million cannot be recovered. Thus, it is a sunk cost.
Similarly, if a company ABC purchases new machinery for the production facility for $ 500 million. Regardless of the choice whether the company continues with the plan of manufacturing the cost is sunk.
Important Considerations with Sunk Costs
If a sunk cost relates to a future cash flow and can be recovered, it is not a sunk cost. For example, suppose the company ABC changes the production plans. However, it can resale the machinery at a discounted price of $ 450 million. The cost incurred becomes recoverable and thus is not a sunk cost.
Sunk costs are different from relevant costs or committed costs. Since sunk costs cannot be recovered, they should affect a decision of future investment. All future investment decisions should be made by analyzing the relevant costs.
Opportunity Costs v Sunk Costs – Key Differences
A sunk cost cannot be recovered and an opportunity cost cannot be obtained. Thus, both represent a form of lost opportunity or unachieved goal for an investor or a company.
The key difference between the two is that an opportunity cost is a foregone choice for a future event. Whereas, the sunk cost is an already incurred cost for a past event.
Another key difference between the two is that an opportunity cost is uncertain. It represents an estimation of a lost opportunity. Contrarily, the sunk costs are certain, incurred, and irrecoverable.
For accounting practice, some sunk costs can be amortized by the company. For instance, a company would amortize the cost of purchasing machinery. However, that will be only an accounting entry with no real cash flow.
Similarly, an opportunity cost would only affect a decision if there was a comparable option available. For example, an investor must not compare investing in a municipal bond against a high-risk stock investment.
Sunk costs can be easily confused with the relevant costs of an investment appraisal. Also, an opportunity cost can be considered a certain opportunity missed in investment evaluations. Thus, analysts must consider the broader picture when analyzing both sunk and opportunity costs.