Opportunity cost, sunk cost, and marginal thinking
Compare future benefits and costs while accounting for the best alternative you would give up.
Compare alternatives using what changes and what is forgone, excluding past costs that the decision cannot recover.
Overview
The owner of Orchard Photography has spent $900 advertising a proposed workshop. She now has an opportunity to book portrait sessions on the same Saturday. She wants to run the workshop because “we have already put money into it.”
The advertising payment cannot be recovered under either option.
Both businesses and all figures in this lesson are fictional teaching assumptions.
Recall Lesson 015: What should a manager specify before comparing solutions to a vague concern?
Three ideas for comparing choices
Opportunity cost is the value of the best alternative you give up. When two jobs need the same working day, choosing one means losing the benefit available from the other. Count the best feasible alternative, rather than adding together every imaginable use of the time.
A sunk cost is a past cost you cannot recover. It is the same regardless of what you choose now. Past spending can inform your judgment about what works, but spending more cannot reverse an unrecoverable payment.
Marginal thinking compares the additional benefits and costs of a change. “Marginal” means additional here. OpenStax explains these principles as comparing what changes between choices while excluding irrecoverable past costs. Source
Ask what revenue, expense, use of time, or customer consequence changes between alternatives. A positive return compared with doing nothing can still be inferior to another available use of the same resources.
Which costs belong in the comparison
For today's short-term examples, calculate each option's future revenue minus the future costs caused by that option. Then compare those amounts. Expenses that stay identical under both choices cancel out of the comparison, although the business must still cover them overall.
Do not classify a cost solely by whether someone calls it fixed. A one-time room rental required only for a workshop belongs in that workshop's calculation. Existing rent that remains payable under either choice does not change the difference between them.
Check whether past payments are actually unrecoverable. A refundable deposit has value you would give up by using it. Equipment bought earlier might have a resale value today. The original payment and today's available recovery are different amounts.
Opportunity cost need not appear on a supplier invoice. An owner's time can displace paid work, rest, or family time. If a consequence cannot be valued credibly in dollars, describe it separately instead of inventing a precise price.
Worked example
Orchard must choose by Wednesday. Either option uses the owner's entire available Saturday, including preparation and editing. Neither has been accepted, neither can be moved, and both can be delivered as described. Existing expenses stay unchanged.
| Saturday option | Revenue | Future costs caused by the option |
|---|---|---|
| Workshop for 20 people | 20 × $90 = $1,800 | Materials: 20 × $30 = $600; room rental: $300 |
| Four portrait sessions | 4 × $400 = $1,600 | Printing and assistance: 4 × $125 = $500 |
Assume reliable attendance and payment, enough cash for either option, and no other differing costs or future customer benefits. Ignore taxes. The $900 advertising payment is separate from the costs in the table and is nonrefundable.
The workshop leaves $1,800 − $600 − $300 = $900 before unchanged expenses. Portrait sessions leave $1,600 − $500 = $1,100. These amounts are contributions toward unchanged expenses and profit, not the studio's total profit.
Choosing the workshop gives up the $1,100 available from portraits. That is the opportunity cost of using Saturday for the workshop. The workshop's advantage over portraits is $900 − $1,100 = −$200. Choose portraits on the supplied facts.
The forgone amount is $1,100, rather than the portraits' $1,600 revenue, because declining portraits also avoids their $500 costs. Once you compare $900 with $1,100, you have already included the opportunity cost. Do not subtract $1,100 a second time.
The advertising payment remains $900 under either choice. Excluding it from this decision does not erase the earlier expense.
If the portrait bookings disappear, the comparison changes. With no better alternative, running the workshop would add $900 before unchanged expenses. Past spending neither requires continuing nor automatically justifies stopping.
Exercise
Allow 7–9 minutes. You manage established printer Pine Press. One machine has ten hours available next week. Two unaccepted orders each require all ten hours, so only one can be completed. Decide today.
A custom order would earn $4,000 and require $2,600 of future materials, labor, and setup costs. A standard order would earn $3,500 and require $1,800 of future materials and labor costs.
Pine already spent $2,000 on custom-order design work. That payment is nonrefundable, has no resale value, and cannot be reused. Next week's $800 equipment lease payment is due under either option. Neither order changes it.
Assume full collection after delivery, adequate cash for either order, no other differing costs or relationship benefits, and no way to move or outsource the work. Ignore taxes.
- Identify the sunk cost and the future cost that stays unchanged. Explain why neither determines which order is better.
- Calculate each order's future revenue less its additional costs. Which should Pine choose, and by how much?
- State the opportunity cost of accepting the custom order. Explain why it differs from the standard order's revenue.
- What custom-order price would make the two options financially equal if costs stayed unchanged? Name one assumption to verify before committing.
Attempt the exercise before reading on.
Answer
The $2,000 design payment is sunk. Today's choice cannot recover it. The $800 lease is a future obligation, but it is identical under both choices. It still needs paying; it does not favor either order.
The custom order leaves $4,000 − $2,600 = $1,400. The standard order leaves $3,500 − $1,800 = $1,700. Choose the standard order: it contributes $1,700 − $1,400 = $300 more toward unchanged expenses and profit.
Subtracting the common $800 lease from both amounts gives $600 and $900. Their difference remains $300. These are not total company profits.
Accepting the custom order would give up $1,700 from the standard order. Using $3,500 as the opportunity cost would overlook the $1,800 costs avoided when that order is declined.
To match the standard order, the custom price must cover its $2,600 future costs plus the $1,700 forgone contribution: $2,600 + $1,700 = $4,300. At that price, both leave $1,700. The earlier $2,000 does not change this threshold.
Confirm the standard customer's commitment and the ten-hour production estimate. A lost booking or unexpected setup requirement would change the comparison. Any important customer relationship consequence would also need consideration.
Recall answer: Specify the decision, alternatives, success criteria, constraints, decision maker, and deadline. Today's comparison then identifies the costs and benefits that change between those alternatives.
Applying this lesson
For your next choice, separate unrecoverable past spending, future amounts that differ, and the best alternative you would give up. Compare from today forward, then check cash timing and consequences the arithmetic leaves out.
Sources
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