These terms are widely used in the business world and Cost Accounting. Let's have a look what do they exactly mean.
It is the difference between the cost of two alternative decisions, which the management seems apt. This cost occurs when a business faces several similar options, and a choice must be made by picking one option and dropping the other.
Let us understand this with an example- Lets suppose Bestaste Company is a food giant that primarily relies on traditional methods for marketing. Then, a new experienced marketing director suggests that the company should focus on television ads and social media marketing to reach a broader client base.
The food giant currently spends 6000 on traditional advertisements every month. If the food giant adopts the new advertisement techniques, they will spend 10000 per month in advertising expenses.
In accounting terms, Opportunity Cost refers to the potential benefits or incomes that are foregone by choosing one option over another. Business executives must choose between the available and feasible options, but the decision should be made after considering the opportunity cost of not obtaining the benefits offered by the option not chosen.
Lets continue with the previous example in order to understand Opportunity Cost- In the case of Bestaste Company, moving to television ads and social media marketing exposes the company to a broader customer base. If the company earned 25,000 using the current marketing platforms, moving to the more advanced advertising platforms might result in a 40% revenue increase to 35,000.
The move places the opportunity cost of choosing to stick to the old advertising method at 10,000 (35,000 – 25,000). The 10,000 is the income that Bestaste would forego for remaining with the old marketing techniques and failing to adopt the more sophisticated marketing models.
Sunk Cost refers to cost that a business has already incurred, but that cannot be eliminated by any management decision. An example is when a company purchases an asset that becomes obsolete or unusable within a short period of time, and the benefits that could be availed by the asset are no longer available.
Consider the company Bestaste engaged in cigarette manufacturing that acquires an advanced machine to double its current production of cigarettes. As soon as the company puts the new machine into use, the government bans the manufacturing of cigarettes in the country and makes it a crime for any person to manufacture or sell cigarettes. The new regulation renders the machine and the produced products obsolete, and the company cannot change the government’s decision. It is an expense that cannot be reversed or is a sunk cost.