Fundamentals of Financial and Cost Accounting · Classification of Costs (CAS 1)

Sunk Cost, Opportunity Cost and Other Decision-Making Costs

Updated 10 October 2026 · Fact-checked

Decision-making costs are costs you compare when choosing between alternatives. A cost is relevant only if it is a future cost that differs between the options. Sunk costs are past and irrelevant. Opportunity, differential, marginal and avoidable costs are relevant. Imputed costs are notional. Out-of-pocket costs need cash payment.

Understand Decision-Making Costs: Sunk, Opportunity, Marginal and Others

A business decision is a choice about the future. So the only costs that matter are those that change because of the choice. This idea is called relevant cost. A cost that does not change with the decision is an irrelevant cost.

Sunk cost is money already spent in the past that cannot be recovered whatever you decide now. A machine bought last year for ₹5,00,000 is a sunk cost. It stays the same whether you use the machine or not, so it is irrelevant to the decision.

Opportunity cost is the benefit you give up by choosing one alternative over the next best one. If you use your own shop instead of renting it out for ₹20,000 a month, the rent you lose is the opportunity cost. No cash is paid, but it is a real cost of the decision and it is relevant.

Marginal cost is the extra cost of producing one more unit. It is usually the variable cost per unit. Differential cost is the difference in total cost between two alternatives or two activity levels. It can include a change in fixed cost, so it is wider than marginal cost.

Three more terms appear often. Imputed cost is a notional cost that is not actually paid, such as interest on your own capital or rent on your own building. Out-of-pocket cost is a cost that needs a cash payment to outsiders now or soon. Avoidable cost is a cost that can be saved if you drop a product or activity. Unavoidable cost continues even if you drop it.

Key formulas to remember

Relevant cost test: Relevant cost = future cost that differs between alternatives; Both conditions are needed. Past costs and common costs are irrelevant.
Differential cost: Differential cost = Cost of Alternative A − Cost of Alternative B; Also used for the change in total cost when output changes. Can include fixed cost changes.
Marginal cost per unit: Marginal cost per unit = Direct material + Direct labour + Direct expenses + Variable overhead per unit; Assumes fixed costs do not change with one more unit.
Opportunity cost: Opportunity cost = Benefit lost from the best rejected alternative; Take only the best alternative given up, not the sum of all.
Sunk cost rule: Sunk cost → ignore in decisions; Past, unrecoverable and unaffected by the decision.

How to solve Decision-Making Costs: Sunk, Opportunity, Marginal and Others questions

Use this sequence for any question that asks you to name a cost type or to choose between alternatives.

1Read the options and note the decision being made.
2Mark each cost as past or future. Past and unrecoverable costs are sunk, so cross them out.
3Check whether the future cost is the same in every alternative. If yes, it is irrelevant.
4Look for benefits given up, such as lost rent, salary or sale of an asset. Add these as opportunity costs.
5Remove notional items like imputed interest if the question asks for cash or out-of-pocket cost only.
6Compute the differential or marginal figure using only relevant items.
7Choose the alternative with the better relevant result and re-read what the question asked for.

Quickest way: Keyword match for definition questions

When to use it: Use for one-line MCQs asking which cost type fits a description.

Already spent, cannot be recovered: sunk cost.
Benefit given up from next best choice: opportunity cost.
Notional, no cash paid: imputed cost.
Needs cash payment now: out-of-pocket cost.
Extra cost of one more unit: marginal cost.
Change in total cost between alternatives: differential cost.
Can be saved if activity stops: avoidable cost.

Common mistakes in Decision-Making Costs: Sunk, Opportunity, Marginal and Others

Treating sunk cost as relevant because the amount is large.
A big past spend feels like it must matter.
Fix: Ask if the amount changes with the decision. If it does not, ignore it however large it is.
Saying opportunity cost involves a cash payment.
Students link every cost to an expense entry.
Fix: Remember it is a benefit forgone. It is not recorded in the books.
Using marginal cost and differential cost as the same thing.
Both deal with a change in cost.
Fix: Marginal cost is for one extra unit. Differential cost compares alternatives and may include fixed cost changes.
Counting imputed cost as out-of-pocket cost.
Both sound like costs of the owner.
Fix: Out-of-pocket needs cash outflow. Imputed has none, like interest on owner's own capital.
Adding all rejected alternatives to get opportunity cost.
Students think every lost benefit counts.
Fix: Take only the single best alternative given up.

Worked examples

Example 1

Meera owns a shop that she uses for her own business. She could rent it out for ₹25,000 a month. She also paid ₹2,00,000 last year for interior work. She is deciding whether to keep running the shop. What is the opportunity cost per month and which cost is sunk?

Show the solution

The best alternative to using the shop herself is renting it out.
Benefit given up is ₹25,000 per month, so that is the opportunity cost.
The ₹2,00,000 interior work was spent last year and cannot be recovered.
So the interior cost is sunk and irrelevant to the decision.

Answer: Opportunity cost is ₹25,000 per month. The ₹2,00,000 interior cost is sunk.

Example 2

A firm can make 1,000 units at a total cost of ₹80,000 or 1,200 units at a total cost of ₹90,000. Variable cost per unit is ₹40, and fixed cost is ₹40,000 at 1,000 units. Find the differential cost and the marginal cost per unit of the extra output. Is fixed cost changing?

Show the solution

Differential cost = 90,000 − 80,000 = ₹10,000.
Extra units = 1,200 − 1,000 = 200.
Variable cost of 200 units = 200 × 40 = ₹8,000.
Marginal cost per unit = ₹40, the variable cost per unit.
Fixed cost at 1,200 units = 90,000 − (1,200 × 40) = 90,000 − 48,000 = ₹42,000.
Fixed cost rose by ₹2,000, which explains why differential cost of ₹10,000 exceeds ₹8,000.

Answer: Differential cost is ₹10,000 and marginal cost per unit is ₹40. Fixed cost rose by ₹2,000.

Exam tips

Most MCQs are definition or example matching. Learn the one-line meaning of each cost.
If an option says a cost is relevant even though it was already paid, it is almost always wrong.
In numerical questions, strike out sunk and common costs first to save time.
For marginal versus differential, check if fixed cost changes. If yes, differential is the likely answer.
Imputed means no cash. Use this to eliminate options quickly.

Practice questions from Classification of Costs (CAS 1)

Decision-Making Costs: Sunk, Opportunity, Marginal and Others: frequently asked questions

What is the difference between sunk cost and opportunity cost?

Sunk cost is a past spend that cannot be recovered and is ignored in decisions. Opportunity cost is the benefit lost by choosing one option over the next best one and must be considered. Sunk cost looks back, opportunity cost looks forward.

What is marginal cost versus differential cost?

Marginal cost is the extra cost of one more unit, usually variable cost. Differential cost is the difference in total cost between two alternatives or activity levels. It may also include a change in fixed cost.

Give examples of relevant and irrelevant costs.

Relevant: future raw material cost that differs between options, or rent forgone. Irrelevant: money already spent on a machine, or an overhead that stays the same under every option.

What are imputed cost and out-of-pocket cost?

Imputed cost is a notional cost with no cash payment, such as interest on owner's own capital. Out-of-pocket cost needs a cash payment to an outside party, such as wages or rent paid.