Finance/Accounting 101: Sunk and Opportunity Costs

Opportunity Cost (Finance): Is the cost one misses out on, when you go with one option over another (Investopedia, n.b.a.).  This usually occurs when you have limited resources.  If you have little money to budget, if you factor out all your needs, you only have so much left for your wants.  You cannot buy all your wants and therefore when you buy one want you may not be able to afford another.  The biggest limited resource we have is time, and time is usually associated with money.  When I did my doctorate, I couldn’t use that time to go to law school, so my opportunity cost was law school during my doctorate.  However, going to law school now will mean that the opportunity cost I have to pay is time with family, friends, and pets.  As Ursula from the little mermaid said “You can’t get something for nothing,” even free things have their cost.  You can get a free cookie, cake piece, ice cream, or pizza slice, but that may mean more time in the gym to burn those unneeded calories.

Opportunity cost can be calculated in dollars, time, or any other metric, but since you forgo that opportunity in exchange for another, you cannot claim it in accounting purposes. However, calculating it can be extremely useful for decision making.

Sunk cost (finance/accounting): It is the cost that has already been incurred to date that cannot be recovered, especially when deciding whether to continue to invest or divest (Investopedia, n.d.b.).  There is a fallacy that we as humans tend in include sunk cost when making our decision to continue moving over.  For instance, if you had a major in college, let’s say physics and you are on your senior year, and you realized you want to be a biologist instead.  The decision you have to make is to finish physics as a double major with biology, finish physics and stay in that field, or stop studying physics and pursue biology.  The sunk costs are all the classes that won’t count towards a degree in physics.  Some people may look at the problem and say they are 3-4 classes away from the degree, I might as well suck it up.  Or others may say, I have enough for a minor, and I should cut my losses.  When making a decision, like this, we should look at the problem new, without looking at what was already invested, because if you hate physics, but are 23-4 classes away, you will hate those three or four classes and your future career.  It makes no sense to continue.

In sunk cost, it doesn’t mean that you cannot try to claim some value from what you invested in.  For instance, claiming a minor in physics, or seeing which of those credits can transfer to lessen the load of classes you want to take for a biology major.  That is a smart way to minimize sunk cost.  But, if there is a sunk cost, it is ok.  The problem is not to keep wasting resources towards a lost cause and increasing the sunk cost.

Personally, I fall victim to this sunk cost fallacy a few times, when it comes to being a life-long learner.  Especially when reading a book.  Just because I checked out a book in the library doesn’t mean I have to read it from cover to cover, especially if I don’t like it after a few chapters.  But, again we have a tendency to want to see things through to the end.  The letting go of a book exercise is a great exercise in building resilience against the sunk cost fallacy.  Give it a try.  Has there been a book on your nightstand that you just don’t want to read anymore? Then let it go.  Donate it to a library, to a school, etc.  Relish in the fact that you didn’t give in to the sunk cost fallacy to keep reading that book to the end.

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