Question

Do you believe a firm must have a firm grasp of the concepts of differential cost, opportunity cost and sunk cost to be effective in making business decisions? Please be sure that your first post talks about these three different types of costs. Consider giving examples - especially if you have examples within your own employment experience. Or - you can look for some online resources that offer you some other facets of this topic to discuss so that it isn't just a rehash of the textbook.

Answer 1

Differential cost refers to the difference in cost between two projects. This is useful in decision making since the higher the difference in cost, higher will be the preference towards the low cost project. For example, constructing a larger plant will have higher maintenance cost as opposed to constructing a smaller plant and this differential cost must be taken into consideration while making the decision.

Similarly opportunity cost is an important concept because this represents the cost of the next best alternative. In assessing two projects, the opportunity cost that arises due to selection of one project must be taken into account. For example, if I am considering building a plant on a piece of land, I also have the opportunity to sell this land and get its market price immediately which I will lose if the plant is constructed. Hence I must take this cost into account.

Sunk cost is that cost which has been incurred earlier and this is irrelevant in decision making. For example, a business has already incurred expenditure for research and development after which it has two decisions to make. Either decision will not alter the expenditure already incurred and so this is sunk cost.