Marginal Analysis, Sunk costs, Opportunity costs and other related concepts

Marginal analysis is also widely used in microeconomics when analyzing how a complex system is affected by marginal manipulation of its comprising variables. In this sense, marginal analysis focuses on examining the results of small changes as the effects cascade across the business as a whole.

Marginal analysis compares the additional benefits derived from an activity and the extra cost incurred by the same activity. It serves as a decision-making tool in projecting the maximum potential profits for the company by comparing the costs and benefits of the activity.

Marginal analysis is an examination of the associated costs and potential benefits of specific business activities or financial decisions. The goal is to determine if the costs associated with the change in activity will result in a benefit that is sufficient enough to offset them. Instead of focusing on business output as a whole, the impact on the cost of producing an individual unit is most often observed as a point of comparison.

Marginal analysis can also help in the decision-making process when two potential investments exist, but there are only enough available funds for one. By analyzing the associated costs and estimated benefits, it can be determined if one option will result in higher profits than another.

Marginal analysis and variables

When you are using marginal analysis for decision-making, you need to take cost and production variables into consideration. The quantity of the products you’re producing is the most common variable companies evaluate. However, there are others, such as the shipping costs, which increase as you produce and distribute a higher number or weight of products. By making incremental changes in production and monitoring the benefits and costs that accompany those changes, you can choose from a range of production levels with varying levels of profitability.

Marginal analysis and opportunity cost

In order to understand the cost and benefit of certain activities, you must also understand opportunity cost. An opportunity cost is a valuable benefit that you miss when you choose one option over another. For example, if a company has room in its budget for another employee and is considering hiring another person to work in a factory, a marginal analysis indicates that hiring that person provides a net marginal benefit. In other words, the ability to produce more products outweighs the increase in labour costs. However, hiring that person still may not be the best decision for the company.

Marginal analysis and observed change

In some cases, it may make sense for a company to make small operational changes and then perform a marginal analysis afterward to observe the changes in costs and benefits that occurred as a result of those changes. For example, a company that manufactures children’s toys may choose to increase production by 1% to see what changes occur in quality and how it impacts resources.

If the managers observe that the benefits of a production increase outweigh any additional costs the company incurs, they may choose to maintain the higher production rate or even raise production by 1% again to observe the changes that occur. Through small modifications and observed change, companies can identify optimal production rates.

Limitations of Marginal Analysis

One of the criticisms against marginal analysis is that marginal data, by its nature, is usually hypothetical and cannot provide the true picture of marginal cost and output when making a decision and substituting goods. It therefore sometimes falls short of making the best decision, given that most decisions are made based on average data.

Another limitation of marginal analysis is that economic actors make decisions based on projected results rather than actual results. If the projected income is not realized as predicted, the marginal analysis will prove to be worthless.

For example, a company may decide to start a new production line based on a marginal analysis projection that the revenue will exceed costs to establish the production line. If the new production line does not meet the expected marginal costs and operates at a loss, it means that the marginal analysis used the wrong assumptions.

Sunk Cost

In economics and business decision-making, a sunk cost (also known as retrospective cost) is a cost that has already been incurred and cannot be recovered. Sunk costs are contrasted with prospective costs, which are future costs that may be avoided if action is taken. In other words, a sunk cost is a sum paid in the past that is no longer relevant to decisions about the future. Even though economists argue that sunk costs are no longer relevant to future rational decision-making, in everyday life, people often take previous expenditures in situations, such as repairing a car or house, into their future decisions regarding those properties.

A sunk cost refers to money that has already been spent and cannot be recovered. In business, the axiom that one has to “spend money to make money” is reflected in the phenomenon of the sunk cost. A sunk cost differs from future costs that a business may face, such as decisions about inventory purchase costs or product pricing. Sunk costs are excluded from future business decisions because the cost will remain the same regardless of the outcome of a decision.

An accounting issue that encourages this adverse behavior is that capitalized costs associated with a project must be written off to expense as soon as the decision is made to cancel the project. When the amount to be written off is quite large, this encourages managers to keep projects running over a longer period of time, so that the expense recognition can be spread out over a longer period of time, in the form of depreciation.

All sunk costs are fixed costs but not all fixed costs are sunk costs. The difference is that sunk costs cannot be recovered. If equipment can be resold or returned at the purchase price, for example, it’s not a sunk cost.

Bygones principle

According to classical economics and standard microeconomic theory, only prospective (future) costs are relevant to a rational decision. At any moment in time, the best thing to do depends only on current alternatives. The only things that matter are the future consequences. Past mistakes are irrelevant. Any costs incurred prior to making the decision have already been incurred no matter what decision is made. They may be described as “water under the bridge”, and making decisions on their basis may be described as “crying over spilt milk”. In other words, people should not let sunk costs influence their decisions; sunk costs are irrelevant to rational decisions. Thus, if a new factory was originally projected to yield Rs 100 crore in value, and after Rs 30 crore is spent on it the value projection falls to Rs 65 crore, the company should abandon the project rather than spending an additional Rs. 70 crore to complete it. This is known as the bygones principle or the marginal principle.

Fallacy effect

The bygones principle does not accord with real-world behavior. Sunk costs do, in fact, influence people’s decisions, with people believing that investments (i.e., sunk costs) justify further expenditures. People demonstrate “a greater tendency to continue an endeavor once an investment in money, effort, or time has been made.” This is the sunk cost fallacy, and such behavior may be described as “throwing good money after bad”, while refusing to succumb to what may be described as “cutting one’s losses”. For example, some people remain in failing relationships because they “have already invested too much to leave.” Others buy expensive gym memberships to commit themselves to exercising. Still others are swayed by arguments that a war must continue because lives will have been sacrificed in vain unless victory is achieved. Likewise, individuals caught up in psychic scams will continue investing time, money and emotional energy into the project, despite doubts or suspicions that something is not right. These types of behaviour do not seem to accord with rational choice theory and are often classified as behavioural errors.

Plan continuation bias

A related phenomenon is plan continuation bias, which is recognised as a subtle cognitive bias that tends to force the continuation of an existing plan or course of action even in the face of changing conditions. In the field of aerospace it has been recognised as a significant causal factor in accidents, with a 2004 NASA study finding that in 9 out of the 19 accidents studied, aircrew exhibited this behavioural bias.

Opportunity costs

In microeconomic theory, the opportunity cost of an activity or option is the loss of value or benefit that would be incurred (the cost) by engaging in that activity or choosing that option, versus/relative to engaging in the alternative activity or choosing the alternative option that would offer the highest return in value or benefit.

Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. Because by definition they are unseen, opportunity costs can be easily overlooked. Understanding the potential missed opportunities foregone by choosing one investment over another allows for better decision-making.

Formula and Calculation of Opportunity Cost

Opportunity Cost = FO−CO

where:

FO = Return on best foregone option

CO = Return on chosen option

Explicit Costs

Explicit costs are the direct costs of an action (business operating costs or expenses), executed either through a cash transaction or a physical transfer of resources. In other words, explicit opportunity costs are the out-of-pocket costs of a firm, that are easily identifiable. This means explicit costs will always have a dollar value and involve a transfer of money, e.g. paying employees. With this said, these particular costs can easily be identified under the expenses of a firm’s income statement and balance sheet to represent all the cash outflows of a firm.

Examples are as follows:

• Land and infrastructure costs
• Operation and maintenance costs; Wages, Rent, Overhead, Materials

Implicit Costs

Implicit costs (also referred to as implied, imputed or notional costs) are the opportunity costs of utilising resources owned by the firm that could be used for other purposes. These costs are often hidden to the naked eye and aren’t made known. Unlike explicit costs, implicit opportunity costs correspond to intangibles. Hence, they cannot be clearly identified, defined or reported. This means that they are costs that have already occurred within a project, without exchanging cash. This could include a small business owner not taking any salary in the beginning of their tenure as a way for the business to be more profitable. As implicit costs are the result of assets, they are also not recorded for the use of accounting purposes because they do not represent any monetary losses or gains. In terms of factors of production, implicit opportunity costs allow for depreciation of goods, materials and equipment that ensure the operations of a company.

Examples of implicit costs regarding production are mainly resources contributed by a business owner which includes:

• Infrastructure
• Human labour
• Time

Non-monetary cost

Seeking a certain profit might have implicit costs such as health, ecological, or other costs. Many of those costs may not be paid directly or immediately after; they may also not be paid by those responsible for the costs. For example, if a company pollutes, the company’s accountants may not be responsible for the costs, but the costs may be externalized onto other people in the case of local pollution, or the entire population, in the case of global warming.

Smoking may personally have higher direct costs, such as health costs; it may also generate direct losses economically or increase the prevalence of health problems which could harm the economy. The tobacco industry generates losses for many sectors, however, for the tobacco industry no cost may be paid. Quitting smoking may reduce hidden costs choosing to take a walk instead of smoking could be beneficial to one’s health, for example. Choosing to work half-time may allow for more rest for a sick person.

Externalities are a kind of cost generated from one economic agent to another. For example, the restaurant sector may be growing but obesity may generate a cost, monetary or otherwise in many domains, such as an increased difficulty in recruiting fit firefighters. Some sectors are growing extensively from such costs, private or not. Dentists are needed partly because both sugary foods and tobacco generate work and demand.

Plane travel may generate externalities by contributing to global warming and air pollution, which harms many sectors such as agriculture and nature tourism. Short-term profit may lead to high costs later. Refusing to invest in infrastructure or maintenance for a company may lead to a loss of customers.

The development of tourism has driven the local consumption industry and a series of related economic growths. At the same time, it can lead to excessive development and utilization of tourism resources, serious environmental damage, and a large number of negative impacts affecting the lives of local people. Overcrowding on holidays may lead to a poor experience and a loss of tourists.