Chapter Two

Hidden Costs: Opportunity Costs and Sunk Costs

Memo to Managers

“ I do not know you, nor do I know the business you are in. But I do know one thing. Some of your highest ongoing costs are for things you already bought and paid for.” from Executive Economics: Ten Essential Tools for Managers

Costs and the Economic Way of Thinking

• Economics deals with costs in a couple of unique ways

• Our view of costs is very inclusive

• Good decision-making in business requires you to use of the tools economists have developed in thinking about costs

Opportunity Costs

• the highest valued alternative forgone as the result of choice.

“Choosing is refusing.”

• When we make a particular choice from a list of alternatives we rank them and choose the most valuable alternative. In doing so we refuse all other choices on that list.

• Opportunity cost is the next or second best choice. You choose the first-best option and the next options is your opportunity cost.

Opportunity costs are relative.

• It is always measured relative to alternative choices.

• It is the most highly valued alternative forgone.

Opportunity costs are subjective.

• The valuation of alternative choices may differ by decision-maker.

• An individual decision-makers opportunity costs may vary over time.

Any Saturday Morning

• Choices, choices, choices…– Watch Ren and Stempy cartoon– Sleep-in– Mow the yard– Play baseball with my children– Write power point slides for SMPU class– Clean the pool

Any Saturday Morning

• I could choose any of these and in fact I value them all.

• To choose I must compare alternatives

• To choose I must rank-order the list of possible activities

Any Saturday Morning

1. Write power point slides for SMPU class

2. Play baseball with my children

3. Watch Ren and Stempy cartoon

4. Clean the pool

5. Mow the yard

6. Sleep-in– These are now ranked in the order I would

choose at this time in my life.

Choices often include many options,

• but…opportunity costs are not the summed list of all possible choices. It is a singular cost.

• The opportunity cost according to my ranking here is playing baseball with my children. That is the next highest valued alternative.

Opportunity Costs are subjective…

• I may face the same choices next Saturday and choose to watch Ren and Stempy cartoons! – If I did choose Ren and Stempy next week what

would be my opportunity cost? – The highest valued alternative forgone (i.e.,

whatever is next on my list.)

Applications to business decisions

• Recognize that using opportunity costs means thinking outside of the traditional accounting framework

• Accounting deals primarily with historical costs

• Economic decision-making is future oriented

An Economic Approach to Costs

• Read An Economic Approach to Costs

Economic Costs Vs. Accounting Costs

• Economic costs will almost always be higher than accounting costs due to our inclusion of opportunity costs

• Opportunity costs are only relevant to decision-making, they do not show up on an accounting balance sheet or an income statement but they have great influence on both

Economic Profit vs. Accounting Profit

• As shown in the reading, accounting profits are almost always to high because accounting profits do not include foregone alternatives

Read Chapter Two on the Coca- Cola Company

• What was Roberto Goizueta doing?– Charging his business units a fee for the use of

stockholders money.

• Why was Goizueta doing this?– To require managers to take into account the

hidden costs we call opportunity cost.

Read Chapter Two on the Caroline’s Cookies

• Why was A&P charging Caroline a fee for shelf space?– Because shelf space in an A&P is valuable.

• “Each yard of shelf space in my store generates about $10,000 in sales (revenues) every week!”

– If I put Caroline’s Cookies on that shelf space what is my next best alternative?

• My opportunity costs (or next best alternative) is top generate $10,000 in revenues from the product that was in the space she is now in.

Time is Money

• Suppose you had two client willing to hire you as a consultant.

• Suppose the service you provided was essentially the same for both clients.

• Client A offers $150 an hour

• Client B offers $200 an hour

Client A or Client B?

• I hope you choose client B!– Why?

• The opportunity cost of working for Client B is what you could have earned working for Client A – or $150 per hour.

• The opportunity cost of working for Client A is what you could have earned working for Client B – or $200 per hour.

• Your lowest opportunity cost is incurred by foregoing $150 an hour in favor of $200 an hour.

Sunk Costs

• “Sunk Costs are sunk.”– They have already been made, they are

historical and cannot be recovered, so they are irretrievable.

– Forget about them – they are irrelevant to your future.

Sunk Costs

• Extremely difficult for managers to deal with – ego trumps clear thinking

• Often requires them to admit they made a mistake

• For these reasons they are prevalent and extremely costly to firms