Opportunity Cost and Sunk Cost for Decision Making
Opportunity cost and sunk cost are two important economic concepts which often affect how businesses make decisions. When you say yes to anything, you are explicitly or implicitly saying no to something else. As illustrated in the cover photo I took at the North Carolina Museum of Art earlier this month, you can only handle so many things in life at the same time. Opportunity cost is what you give up when you choose between options. The key to minimize opportunity cost is by choosing the option that benefits the most. Sunk cost, on the other hand, is expense that is already gone. You have already paid for it and you can’t get it back. The key is not to let sunk cost have too much influence on your decisions for the future. Conceptually the numbers of opportunity costs and sunk costs are almost limitless, but in the context of individual decisions or business decisions, they would generally include money, time or effort. The concepts, while mostly used in economic sense for business or investment decisions, are equally applicable for many aspects of personal decisions.
Opportunity Cost
For business decisions, opportunity cost informs business decisions in several dimensions. First of all, in a business world where resources always limited, business strategy is not just about the importance of what you do but more about clarity of what you do not do. Opportunity cost brings sharp focus on the decisions you make vs. the next best alternative. People often focus on the proposed action vs doing nothing which most often is not the benchmark one should be comparing against. Secondly, opportunity cost analysis also helps creating business urgency for decision making which is getting increasingly important in dynamic business environment. When the opportunity cost is high, expediting decision making is often better than continued information gathering and analysis for perfection. On the other hand, your pursuit of certain objectives should be more persistent if the opportunity cost is low.
Sunk Cost
Very often you hear statements such as “the system does not really work, but we already made the investment” or “we already paid for it, we might as well go for it.” The hardest things to let go are things emotionally attached to decisions you already made. The more time or money that you have invested in a person, product, or idea, the harder it would be to move on. It is not just about individual decisions. Businesses have extremely difficult time to kill bad projects. Investors often hold on with stocks which have lost significant values and hope they would somehow recover the loss even though there are better investment options.
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The general observation is that we human tend to give too much attention to sunk costs and not enough focus on opportunity costs for decision making. It is true for business as well as individual. In reality, decision making really should focus on the future, not the past. Though the past can teach us a lot, the past is gone and won’t come back. Don’t forfeit future benefits to justify a past decision. Leverage your energy for future opportunity rather than worrying about the past. On that note, I will share with you a little secret. If you had assumed reading my articles was free, it is not. The opportunity cost is your precious time which could have potentially been spent on doing something else. On the other hand, if you already finished reading, that is too bad. It is already sunk cost regardless of how you feel about the usefulness of the article. With that said, I certainly hope it has been time well spent for you.
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👉 Finance, Planning, Control & Analysis - Business Partnering, Analyst | 💻 Budget, Ops - Production Planning | 🎯 KPI's Monitoring.
3yAs FP&A's & Controllers, it's good we also take a look at the "empty glass, and not always "half full" as the motivational leaders discourse says. (there will always be a sunk cost if we do not properly manage efficiency, for example). Thanks again for your words Xinjin Zhao! 😀
EX state head of MP And MH at Suzlon Energey ltd at Suzlon Wind Energy Corporation (SWECO)
3yI think what you described is leverage judgement and vision for decision making but use data to track progress and ensure the decision was on track. Make sense. Opportunity cost and sunk cost are two important economic concepts which often affect how businesses make decisions. When you say yes to anything, you are explicitly or implicitly saying no to something else. The key to minimize opportunity cost is by choosing the option that benefits the most. Sunk cost, on the other hand, is expense that is already gone. You have already paid for it and you can’t get it back. The key is not to let sunk cost have too much influence on your decisions for the future. We human tend to give too much attention to sunk costs and not enough focus on opportunity costs for decision making. In reality, decision making really should focus on the future, not the
CEO at Cubitec Engineering
3yWelldone Xinjin....Very educative and practical article....Thanks
Capacity BUILDER at AGP Centric
3yThank you so much for sharing this article! Agree. Sometimes we give too much attention to sunk costs because we are attached emotionally to some projects, services, or even some systems we used and succeeded in the past. I think this may be the reason behind our loss of opportunities. What about the fears associated with decision-making?
Project Manager | PMP®| Lean Management
3yWell said. This issue is not in business decisions only, it’s a vital issue we suffer in all our life sides! We always look to the “past” and neglect our “future” we are loosing our present in regretting our previous actions