Question

In your own words, define sunk cost, avoidable cost, and opportunity cost and understand how to use these concepts in analyzing decisions.

Answer 1

• Sunk Cost: Sunk cost are those costs which have already been incurred by the entity in anything like in material, fixed assets etc. For example Company had purchased an asset 5 years back for $100,000. There is no relevance of such cost in analyzing decisions and these costs are ALWAYS IGNORED while taking a decision.

• Avoidable Cost: Avoidable costs are those cost which can be avoided if some decision is taken or not taken. Avoidable costs are generally extra costs or marginal costs which comes when an entity plan to choose a project or take a decision. These costs are only incurred if entity takes a decision to go for a project or special order. For example, a Company is considering to reprocess the waste material produced and make it a kind of fertilizer and sell it to farmers. To do such reprocess the company requires an additional machinery costing $50,000. In this case machinery cost of $50,000 is a avoidable cost which company can avoid if it doesn't decide to reprocess the waste materials.

Such avoidable costs are ALWAYS CONSIDERED while analyzing the decision.

• Opportunity Cost: Opportunity costs are those 'INCOME' or Inflows or profits that an entity is loosing from next best alternative use of resources by selecting the current resource. For example, Mr. Bean a well qualified CPA earning annual salary of $100,000. Now Mr. Bean decided to pursue MBA from a reputed regular college for which he has to quit his job and do 2 years of MBA. The fees of the MBA college was $50,000 for both the years.

in the above example total cost that Mr. bean incurred for pursuing MBA is not only $50,000 but also salary forgone for 2 years i.e. $200,000. Hence, total of MBA for Mr. Bean = $250,000. In this case $200,000 is opportunity cost.

Such costs are ALWAYS CONSIDERED while analyzing the decision.