Understanding Opportunity Costs And Sunk Costs In Your Business

Opportunity costs? Sunk costs? If you don’t have a background in accounting, these terms may sound like Greek to you.

But the concepts behind them are actually pretty simple. And having a solid understanding of what they mean and how they relate to one another could help you make better decisions as a small business owner.

In today’s guide, we’ll quickly define both of these terms and give real-life examples of each. We’ll end by comparing and contrasting opportunity costs and sunk costs and explain why small business owners need to keep both in mind when making decisions.

Opportunity Costs

Here’s how Dictionary.com defines an opportunity cost.

“The money or other benefits lost when pursuing a particular course of action instead of a mutually-exclusive alternative.”

The core idea behind opportunity costs is quite simple really. When you make one decision you lose out on any gain or benefit that a different choice would have brought you.

For instance, when you decide to leave a large sum of money in cash, you lose out on any interest that you could have gained by investing it.

Opportunity costs aren’t really “costs” at all in the traditional sense of the word. No one is going to bill you for the interest that you lose out by not investing your wealth.

For this reason, opportunity costs (both in our personal and business lives) are easy to miss. They’re somewhat invisible. Unless you purposely think about your opportunity costs, they can easily go unnoticed for years on end.

But you need to be thinking about opportunity costs. Here are a few examples of how opportunity costs can affect a small business.

Renting Vs. Owning

Let’s say that you own a coffee shop. You run your coffee shop out of a building that you own free and clear. You’re not necessarily in a high-traffic area, but you still do fairly good business because of the quality of your product.

One day a customer pops into your store and mentions that he heard about a retail space that just opened up at popular shopping plaza across town.

At first, it may seem like a no-brainer that you’d want to avoid moving your business. After all, no rent means less overhead which means more profit, right? It’s easy math.

Or is it?

How Much More Could You Make?

Let’s say that your coffee shop averages 100 customers a day and the average receipt is $5. That would give you an average daily revenue of $500 and an average monthly revenue of $15,000.

Now let’s imagine that if you moved to the new location, your daily customer volume would jump 50% to 150 customers per day. Keeping the average daily receipt at $5, that would give you an average daily revenue of $750 and the average monthly revenue of $22,500.

That’s a monthly revenue increase of $7,500 ($22,500 – $15,000).

How Much Would It Cost You?

Now, we have to take your new rent cost into account. Let’s say that your current location is 1,500 square feet and the potential new location is 1,500 square feet as well. The new location is asking $2 a square foot, so your monthly rent would be $3,000.

But wait, don’t forget about the building that you’re currently at. If you moved, you could rent out that space.

Let’s say that since your current location is in a less attractive part of town you could only charge $1 per square foot. That would still be $1,500 of rent revenue.

Ok, so now we’re ready to add all this up. Here’s how much extra money you could possibly make per month by moving your coffee shop to the new location.

  • $7,500 (extra income) – $3,000 (rent) + $1,500 (rent revenue) = $6,000 monthly revenue increase
  • Annual revenue increase = $72,000

So by forgoing this opportunity, you could potentially be throwing an extra $72,000 a year down the drain. So much for a no-brainer decision!

General Vs. Specialized Services

When you are trying to build a business, it can be tempting to offer too many services.

Many of us think that choosing the “we do everything” model will lead to more business. And it may make you “busier,” on the front-end. But in the long-run, you may be able to make a lot more money by honing in on specialized services.

When a business owner has a service that’s in an area of specialized knowledge, they’ll probably be able to charge more for it.  But they may also offer other services that are not specialized knowledge.

It’s kind of like the difference between painting a picture and painting a wall.  Both may take the same amount of time…but you’d likely charge a lot more for the picture.  And if you are painting the wall for cheap you are losing the opportunity to paint the expensive picture.

Related: Specialization Vs. Generalization: A Study On Business Strategy

When you take any job, you need to consider which jobs you’ll thereby have to say “no” to and what that could cost you. That’s really the core idea behind opportunity costs and why you need to always keep them in mind.

Here’s a video that explains this further.

Sunk Costs

Here’s how Investopedia defines a sunk cost.

A sunk cost is a cost that has already been incurred and cannot be recovered.

Sunk costs are expenses that are already done and gone. You’ve already paid for them and you can’t get them back. Therefore, you have to be careful about letting them have too much influence on your future decisions.

Let me begin by giving an example from my own life.

My Expensive Coaching Course

When I was thinking about moving into a career where I could teach people about personal finance, I found a financial coaching course that I thought would set me up nicely for a full-time financial coaching business. I spent $1,800 on the course.

Unfortunately, after taking the course I began to doubt if financial coaching could be a viable full-time gig. A few months later, I went to a financial media conference. All of a sudden, I was getting paid writing opportunities.

I could have avoided moving into writing to avoid “wasting” the money I spent on the coaching course. But that money was already down the drain.

I needed to make the best decision for my future, regardless of the money that was spent in the past.

I did and I haven’t looked back. Plus, I’ve been able to use some of my coaching skills from that course in my writing… and it gave me credibility when looking for writing jobs.

Time As A Sunk Cost

One of the hardest sunk costs to let go of as a small business owner is your time.

  • You spend 80 hours training a new employee who ends up being a bad fit.
  • You spend a week teaching your employees a new content management system that you realize six months later is really quite terrible.
  • You spend three months earning your certification in a new service that you want to offer only to discover that the service isn’t nearly as profitable as you had hoped.

In all of these situations, the right decision can be incredibly difficult to make. The more time that you’ve invested in a person, product, or idea, the harder it will be to move on.

But the time you spent in the past is just that. It’s past.

Don’t forfeit future profit or happiness just so you can make a past decision “worth it.”

How Opportunity Costs And Sunk Costs Should Impact Your Decisions

Going back to our coffee shop example one final time, let’s say that you spent a lot of time remodeling and decorating your building. The time and money that you’ve invested in the building could blind you from seeing how profitable a move could be.

Overall, you always want to be looking forward. Always ask yourself, “What’s the best decision I can make for my business today?”

In general, it’s human nature to give too much attention to sunk costs and too little attention to opportunity costs.

But you want to flip the script. Try to spend more time thinking about money that you could be leaving on the table and less time dwelling on the money you’ve spent in the past.

Understanding Opportunity Costs And Sunk Costs In Your Business

 

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