Sunk and Opportunity Costs Sunk

Sunk and Opportunity Costs

Sunk costs refer to costs that are non-recoverable fixed costs. Digital products usually have significant sunk costs (when compared to other fixed costs) in the form of research & development and intellectual property (patents etc.) for the product. If the product is not successful in the marketplace, the costs associated with the product development (intellectual property, labor) cannot be recovered. Thus when making pricing decisions about the product in the future, one should not factor in the sunk costs. If a product's cost structure is made up of sunk costs (no other fixed costs) and zero marginal costs then any price above zero will contribute to the company's bottom line. Other fixed costs that are not sunk (rent, depreciation on equipment etc.) should be factored in when making pricing decisions in the future, since these are ongoing costs to the company. The company will continue to have to pay these costs in the future, this is not the case for sunk costs.(Staff, 2004)

Sunk costs are sums that have already been spent and cannot be recovered. The concept is important because sunk costs are irrelevant to financial decisions. Many people tend to feel instinctively that because an investment has been made it is necessary to get a return on it. This can lead to people rejecting one course of action in favor of another that actually generates smaller cash flows. This can happen to business, portfolio investment, and personal decisions. A common mistake made by investors is reluctance to sell securities at a loss. It does not matter what you paid for shares, if the market price has fallen, you have already made that loss. It is a sunk cost and should be forgotten about. What matters is whether the shares are worth holding or not at the current market price. A key question is whether the shares would still be worth buying at current prices. If not, they are probably not worth holding. (Pietersz, 2007)

When economists refer to the "opportunity cost" of a resource, they mean the value of the next-highest-valued alternative use of that resource. if, for example, you spend time and money going to a movie, you cannot spend that time at home reading a book, and you cannot spend the money on something else. If your next-best alternative to seeing the movie is reading the book, then the opportunity cost of seeing the movie is the money spent and the pleasure you forgo by not reading the book. The word opportunity in opportunity cost is actually redundant. The cost of using something is already the value of the highest-valued alternative use. Nevertheless, as contract lawyers and airplane pilots know, redundancy can be a virtue. In this case, its virtue is to remind us that the cost of using a resource arises from the value of what it could be used for instead. (Henderson, 2002)