There are various business structures around the world. The most basic types are sole proprietorships and partnerships. However, these come with a limited number of owners and capital. Due to these restrictions, some businesses may take the form of corporations. Corporations fix some problems with basic business structures. However, they may also come with some other limitations. What are Corporations?Corporations are one of the most advanced business structures. These represent separate legal entities from their owners. Similarly, corporations can theoretically have unlimited owners, known as shareholders. Unlike other business structures, shareholders can transfer their ownership by selling and buying stocks. However, the corporation’s activities don’t get affected by the transfers of ownership. Corporations often have to abide by several regulations, such as stock market regulations. These regulations exist to keep both the corporation and its investors safe. In most countries, corporations can also take several forms, for example, C Corporations or S Corporations. Each structure can have its advantages and disadvantages. What are the advantages of Corporations?Corporations have various advantages compared to other business structures. These include the following. Limited liabilityOne of the most prominent advantages of corporations is that it limits the liability of owners or shareholders. Since corporations are separate legal entities, owners don't have to suffer from their corporation's liabilities. It means that the personal assets of the owners are safe from obligations. The same is does not apply to other business structures. Unlimited capitalAs mentioned, corporations can have unlimited owners in theory. Therefore, they can also get endless capital theoretically. There are some restrictions to the capital that corporations raise. However, corporations don't have to suffer due to limited capital as with other structures. Perpetual existenceWith sole proprietorships, the business only exists until the owner is alive. Similarly, partnerships can have a limited existence until a partner leaves or joins. However, corporations have perpetual existence. These businesses don't get affected when shareholders buy or sell their stock. Therefore, corporations have a longer lifetime than other business structures. Ownership transferAs mentioned, shareholders can buy and sell a corporation’s stocks at any time. Therefore, the process of ownership transfer is more straightforward compared to other business structures. Shareholders can also get control of a corporation by owning more than 50% of the stock. What are the disadvantages of Corporations?Despite the advantages, corporations can have many disadvantages as well. These include the following. Agency problemsCorporations separate shareholders from the management. It can create various agency problems between both parties. When a company's management starts to act in their own interest, agency problems can arise. For other structures, similar issues may not exist. However, with corporations, agency problems are always an issue. More regulationsCorporations have various regulations to which they must comply. It creates an administrative burden for the corporation and its management. Similarly, it results in more paperwork and, sometimes, the regulations may be considered excessive. Setting up corporations also requires going through a complex process. Double taxationShareholders in corporations have to suffer due to double taxation. First, the corporation has to pay taxes on its earnings. When it distributes its profits to shareholders through dividends, shareholders have to pay tax on it again. Similarly, they have to pay tax on capital gains when disposing of their shares. It can be a disadvantage for many shareholders. ConclusionCorporations are separate legal entities that can have unlimited owners. Shareholders can sell and purchase a corporation’s stocks at any time and gain ownership. Being complex structures and separate entities, corporations can have many advantages. However, they can also come with certain disadvantages. Post Source Here: Corporation Advantages and Disadvantages
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Most businesses start as sole proprietorships. However, once they face limitations, such as capital or expertise limitations, they may convert into partnerships. Partnerships are one of the oldest business structures. They have several advantages and disadvantages. However, it is crucial to understand what these are first. What are Partnerships?Partnerships are businesses where two or more owners combine their resources to operate. These owners may come together for a specific, shared purpose. Usually, they combine their assets, expertise, and skills to benefit from the business mutually. Partnerships have evolved significantly from the past. Now, there are various types of structures within this business structure as well. Most partnerships operate through a partnership agreement or contract. This contract specifies various aspects of the business. It also mentions each partner and how much capital they invested in the partnership. When a partner joins or leaves the business, the partnership agreement gets renewed to include new terms. What are the advantages of Partnerships?Partnerships have many advantages for the owners compared to other business structures. These include the following. More capitalSince partnerships involve more than one individual, these businesses don't have to suffer capital limitations. They can get funds from all involved partners. In case the existing partners cannot pay for additional finance, the business structure allows the inclusion of new partners. This way, partnerships don't run out of capital. Increased expertise and accountabilityUsually, each partner brings some expertise to a partnership. It allows partnerships to benefit from their skills and knowledge to grow the business. Similarly, each partner is responsible for a specific part of the business, which allows for better control and accountability. Fewer legal obligationsWhile partnerships have more legal obligations compared to sole proprietorships, they are still lower than corporations. Therefore, there is lesser administration involved in these businesses, which also results in lesser paperwork. Similar, partnerships don't have to abide by strict market regulations, which is not true for some corporations. Better decision-makingPartnerships allow partners from different backgrounds to come together. As mentioned, each partner brings expertise to the business. It further allows for better decision-making. Since each partner can contribute and increase the decision-making quality, partnerships are better than sole proprietorships. What are the disadvantages of partnerships?Partnerships also have some disadvantages, which include the following. More disputesNot every partner in a partnership will agree to the course of the business it takes. Therefore, it may create more disputes among the partners. These can even result in slower business processes and decision-making. It also creates a “blame game” culture within the business. Lower profitsPartnerships involved sharing profits between partners. Therefore, it results in lower income for each partner than if they were in a sole proprietorship. The profit-sharing ratio is a part of the partnership agreement. Sometimes, partners may also disagree with their share of the profits, which can create further disputes. Unlimited liabilityMost partnerships come with unlimited liability for the partners. In case the business dissolves or legal disputes, they have to repay debts from their personal assets. Although each partner's liability is limited to their profit-sharing percentage, they still have to pay more than they have invested in the business. ConclusionPartnerships are business structures where two or more individuals form a business. Usually, there is a partnerships agreement that defines the terms of the partnership between both partners. Partnerships have various advantages for the partners involved but may also come with some disadvantages. Post Source Here: Partnerships Advantages and Disadvantages Businesses can come in various forms and sizes. For example, these may include sole proprietorships, partnerships, corporations, and many more. There are even more classifications in each type. However, the most basic form is still a sole proprietorship. Sole proprietorships have existed from the beginning of time. These businesses have various advantages and disadvantages as well. What is a Sole Proprietorship?A sole proprietorship is a primary business structure where one person controls and handles all matters. This person is the owner of the sole proprietorship. Similarly, there are no other partners involved in this type of business structure. It makes sole proprietorships much more straightforward. However, that does not imply that this business structure is better than the rest. In a sole proprietorship, the owner has the responsibility of handling all business-related matters. Usually, there is no legal distinction between the owner and the business. However, this business structure can provide the base for more complex business structures in the future. What are the advantages of Sole Proprietorships?There are various advantages of the sole proprietorship business structure compared to others. These include the following. Straightforward to set upSole proprietorships are straightforward to set up. Compared to business structures, these businesses don’t require owners to satisfy the same complex requirements. In most countries, sole proprietors don’t need to register their business to get started either. Lower feesDue to how easy they are to set up, sole proprietorships also have lower setup fees requirements for the owners. They can also use this money to boost their business instead. Sole proprietors can save a substantial amount of money from the lesser fees they have to pay. Given that they have a limited amount of capital, this can be a significant advantage for them. Less paperworkIn most countries, sole proprietorships don't have to meet the same rules and regulatory requirements as other business structures. Therefore, these businesses have to handle less paperwork, which can also save on administrative costs. It can further allow sole proprietors to focus on more important matters for their business. More controlSole proprietors have more control and decision-making power in their business. Compared to other business structures, sole proprietorships allow the owner to be the only authority. It can also save a significant amount of time that other business structures waste in decision-making. What are the disadvantages of Sole Proprietorships?Sole proprietorships can also be disadvantageous in various cases. These include the following. Limited capitalSince sole proprietorships have one owner only, they can raise a limited amount of capital. This limitation can restrict these businesses from expanding or in other primary business activities. These businesses also can't raise finance from other sources due to various restrictions. Unlimited liabilitySole proprietorships come with unlimited liability for the owner. Since the business owner and the business are legally the same in this structure, the sole proprietor faces unlimited personal liability. If it fails to meet its financial obligations, the owner will have to compensate creditors from their personal assets. Limited scopeSole proprietorships have limited scope. These businesses can’t expand to other locations due to various limitations. The owner can’t control the business properly after a certain point, which can limit it. Similarly, there is little or no growth for employees, which results in high employee turnover in this structure. ConclusionSole proprietorships are businesses that have a single owner. Similarly, it is a primary business structure that is different from almost every other structure. There are many advantages of sole proprietorship businesses. However, they also come with various disadvantages. Post Source Here: Sole Proprietorship Advantages and Disadvantages What is a Dividend Reinvestment Plan?A dividend reinvestment plan (DRIP) represents a plan that companies offer to shareholders. Through this plan, shareholders can automatically reinvest their cash dividends in additional shares of the company on the dividend payment date. It may also refer to other programs set up by a brokerage or investment company. Dividend reinvestment plans are usually commission-free and may come with discounts. Usually, shareholders have to opt into the dividend reinvestment plan that a company offers. With this plan, investors can reinvest their income into new shares issued by a company. However, the investor can also opt out of it if they want to receive their cash dividends. DRIPs are beneficial for both investors and companies. How do Dividend Reinvestment Plans work?Usually, shareholders receive dividends through a check or a direct deposit into their bank account. However, with dividend reinvestment plans, they get the option to reinvest the amount that they can receive. The shareholder does not reinvest their income into shares from the market. Instead, they buy newly issued shares directly from the company. Usually, DRIPs are commission-free or may come with a minimal fee for the investor. They also offer a significant discount to the current share price that shareholders can get. However, the issuing company may some limits, for example, a minimum reinvestment amount. Some companies may also extend their dividend reinvestment plans to new investors. For the company, dividend reinvestment plans present a way to obtain capital without any additional requirements. The company also has more control over the process and can start or stop it at any time. What are the advantages of Dividend Reinvestment Plans?Dividend reinvestment plans are beneficial to both the shareholder and the issuing company. These plans allow shareholders to reinvest their dividends without having to pay additional commission or brokerage fees. Similarly, they can buy shares for much cheaper than they would get from the market. It involves lower costs for the company, as it doesn't have to pay market or issuance fees. DRIPs may also come with an option to purchase fractional shares. Therefore, shareholders can benefit even if they don’t meet the requirements to get a full share. They also get a compounding effect on their investments each time they reinvest into a company’s shares. For companies, DRIPs are an inexpensive and straightforward way to raise additional capital. What are the disadvantages of Dividend Reinvestment Plans?Although dividend reinvestment plans come with the option to purchase fractional shares, these are no marketable. For short-term investors, dividend reinvestment plans do not present a real value. Therefore, these plans may not suit them. Similarly, shares purchased through DRIPs are not as liquid as those acquired through the market. Companies may also charge higher prices for their shares with these plans. Therefore, investors may not have any control over the purchase prices that they pay. However, these instances are rare for most companies. Dividend reinvestment plans also cause a dilution of shares in a company. Similarly, shareholders who don't participate in it may end up losing a portion of their ownership. ConclusionDividend reinvestment plans allow shareholders to reinvest their cash dividends in a company’s stock. Usually, they get to invest in newly issued shares at a discount with nominal or no extra charges. These plans are beneficial for both companies and shareholders due to the low cost to both parties. However, they may also come with some disadvantages. Originally Published Here: What is a Dividend Reinvestment Plan What are Ordinary Dividends?Ordinary dividends represent the distribution of a company's profits to its shareholders after an accounting period. For shareholders, dividends are one of the two primary returns they get on their investment. There are other types of dividends as well, such as special dividends. However, ordinary dividends are more common. Shareholders can expect ordinary dividends after regular intervals based on a company's history. For the IRS, dividends may fall into either qualified or non-qualified dividends. The classification is crucial to determine the tax that shareholders have to pay on their income. It is because the taxation procedure for each type of dividend will differ. Therefore, it is crucial to understand what qualified and non-qualified ordinary dividends are. What are Qualified and Non-qualified Dividends?Qualified ordinary dividends represent dividends that meet some criteria specified by the IRS. Any distribution of profits from companies that meets the following criteria will be considered qualified dividends.
Qualified dividends get their name because these qualify for long-term capital gains tax rates. Any distribution of profits that does not meet the above criteria will be considered non-qualified. An ordinary dividend is not a part of the qualified dividend. Therefore, taxation procedures for both will differ. How are Qualified Dividends taxed?Once shareholders can differentiate between the classification of their dividends, they can also determine their taxation treatment. For qualified dividends, investors have to pay tax at 0%, 15%, and 20% depending on their long-term gains tax bracket. There are some specified rules for each tax percentage. For the 0% tax rate, shareholders can qualify if:
Shareholders have to pay a 15% tax on their qualified dividend if they exceed the above limit up to:
Shareholders who exceed the above limits must pay taxes at 20%. For other types of dividends, shareholders have to pay the same rates as their other income. How Are Ordinary Dividends Taxed?The taxation on ordinary dividends depends on the tax bracket in which shareholders are. The IRS provides these tax brackets for income tax each year. Since ordinary dividends qualify in these brackets, shareholders must pay taxes by adding these dividends to their total income. The taxes that they must pay include 10%, 12%, 22%, 24%, 32%, 35% and 37%. Therefore, shareholders may have to pay at least 10% and at most 37% tax on their ordinary dividends. However, the high rate is for the highest tax bracket. The IRS has several limits for shareholders to qualify in each category. These brackets differ for single individuals, married couples, and heads of households similar to qualified dividends. ConclusionOrdinary dividends include any income from the distribution of a company’s profits that shareholders get. Shareholders must differentiate between qualified and non-qualified dividends. Qualified dividends have specific tax rules and are taxed based on the long-term gains tax bracket. For ordinary dividends, shareholders have to pay tax according to their income tax bracket. Post Source Here: How Are Ordinary Dividends Taxed Options are financial instruments that derive their value from underlying securities such as stocks, bonds, etc. These are common in options contracts which offer buyers the opportunity to buy or sell the underlying asset in the future. However, it does not oblige them to do so. Instead, they get the right to the purchase or sale of the underlying asset. Options come in different forms. The classification depends on several factors. For example, call options allow holders to buy the underlying asset while a put option lets them sell it. Similarly, options may come as real and financial options. Both of these are different. Therefore, it is crucial to understand the differences between them. What are Real Options?Real options are mostly applicable to company management. These give a company's management the right to undertake a business opportunity or investment at a specific time. Real options get their name from the fact that they involve tangible assets instead of financial instruments. Usually, most options in the market involve an underlying financial instrument. Real options don't and are, therefore, rare. For companies, real options are crucial for long-term success. These options provide companies with the opportunity to choose the right business opportunity. Through this, they can increase profitability and growth. With real options, a company's management has the choice to make a decision. Similarly, they get the right to reject or abandon a decision, which can be crucial sometimes. Real options can provide a company's management with several types of decisions. These include options to expand, abandon, wait, contract or switch. Since it depends on decision-making, real options get their value from relevant techniques, for example, Net Present Value. The price or value of a real option may depend on the type of decision it contains. Overall, real options relate to decisions and do not have underlying financial assets. These apply to the management of a company or business. What are Financial Options?Financial options are derivatives contracts that get their value from an underlying financial instrument. It may include stocks, bonds, or even an interest rate. Instead of relating to decision-making, financial options provide holders with the opportunity to buy or sell the underlying financial instrument. These options also come with a time and price specification. There are two types of financial options that are common in the market. These include call and put options. As mentioned, call options give holders the right to buy the financial instrument at a specified price at a specified future date. Put options, on the other hand, come with the right to sell the underlying financial instrument. Financial options are prevalent on the stock exchange. However, they may also come over-the-counter. Holders can use financial options to hedge against risks or increase their future gains. Unlike real options, financial options don't get their value from capital budgeting techniques. Instead, they consider several variables. Overall, financial options are derivatives that involve an underlying financial instrument. These do not apply to the decision-making process, unlike real options. ConclusionOptions are financial instruments that derive their value from underlying securities. There are various types of options that may exist. Real options include derivatives that get their value from future decisions. These give the holder the right to make a decision in the future. Financial options are derivatives that get their value from underlying financial instruments, such as stocks or bonds. Originally Published Here: Real Options vs Financial Options Assets are resources that companies own or control and result in future economic inflows. These are expenses that companies and businesses must bear for long-term success. Unlike other expenses, companies cannot charge an asset's total cost to a single accounting period. It is because the matching principle in accounting requires entities to match their expenses with the revenues they help generate. Therefore, companies use depreciation to spread an asset’s cost over various accounting periods. There are several depreciation methods in accounting. However, it is crucial to understand what depreciation is first. What is Depreciation?Depreciation is a systematic process that companies use to spread an asset's cost over various accounting periods. Companies use depreciation to allocate an asset's cost to the period in which it helps generate revenues. The concept of depreciation applies to every asset owned by companies that has a finite life. It includes property, plant, and equipment but usually excludes land. Depreciation helps companies calculate their net income in each accounting period. If a company charges an asset's total cost to a single period, it will distort the true view of its profitability. Therefore, it must allocate it over several accounting periods. What are the various Depreciation methods in accounting?There are several methods for depreciating assets that companies may use. These include the straight-line, declining (or reducing) balance, sum-of-the-years' digits, and units of production methods. Each of these produces varying results for depreciation. Therefore, it is crucial to understand what each of these is. Straight Line DepreciationThe straight-line method of depreciation is the most straightforward way to calculate depreciation. For this method, companies need to establish a useful life for an asset. It also considers the asset's salvage value at the end of its life. Once companies measure both of these, they can calculate the straight-line depreciation using the formula below. Depreciation = (Asset’s Cost - Asset’s Salvage Value) / Asset’s Useful Life Depreciation calculated using the straight-line method will always result in the same depreciation over several periods. Declining Balance DepreciationThe declining balance method of depreciation is a type of accelerated depreciation. With this method, companies must establish a percentage to use for depreciation. Unlike the straight-line method, this method results in higher depreciation in an asset's initial years. Companies use this method for assets that have more utility in earlier years. There are several advantages of using this method over others. Companies may also use the double-declining depreciation method, which accelerates depreciation even further. Sum-Of-The-Years’ Digits DepreciationThe sum-of-the-years’ digits depreciation method is another accelerated depreciation method. It produces higher depreciation than the straight-line method but lower than the declining balance method. With this approach, companies apportion an asset’s depreciation based on the year of its useful life. They use the sum of these years to apportion the depreciation. The SYD method is more appropriate for assets with higher utility in the initial years. Units of Production DepreciationThe units of production depreciation method allocates an asset's cost based on the number of units it produces. Instead of establishing a useful life for it, companies determine the expected number of units an asset will produce. Then, they calculate the depreciation based on the actual production units. With this method, companies experience higher depreciation during high production periods. This method of depreciation is useful for manufacturing companies. ConclusionDepreciation is a technique that companies use to allocate an asset's cost over several periods. There are various depreciation methods in accounting. These include straight-line, declining balance, sum-of-the-years' digits, and units of production methods.
Article Source Here: Depreciation Methods in Accounting What is the Profitability Index?Profitability Index (PI) is a measure of the ratio between the discounted cash flows and the initial investments for a given project. Another name for the profitability index is the Profit Investment Ratio (PIR) or Value Investment Ratio (VIR). Profitability index is prevalent in capital budgeting. Companies use it to measure an investment's potential profitability. Companies use the profitability index to compare various projects and show how much value they create for the investment. PI does not work for single projects as it does not give a definitive result. The profitability index isn't only applicable to capital budgeting and companies. It is also common for investors to use PI to quantify the amount of value created for every unit of investment. What is the formula for Profitability Index?Companies can calculate the profitability index for a project by calculating the present value of future cash flows for it. They must also determine the initial cost of the project. Once they do so, they can use the following formula for profitability index calculation. Profitability Index = Present Value of Future Cash Flows / Initial Investment in the Project The decision rule for the profitability index depends on the various projects under consideration. The higher a project’s PI is, the more feasible it is for the company. When comparing, companies must select the project that has the highest profitability index. ExampleA company, Blue Co., is considering investing in one of two given projects. Both projects are for five years. The company uses a 10% discount rate to discount its cash flows. The first project requires Blue Co. to invest $100,000. The discounted cash flows from the project are as below.
Therefore, the project’s profitability index will be as follows. Profitability Index = Present Value of Future Cash Flows / Initial Investment in the Project Profitability Index = $113,540 / $100,000 Profitability index = 1.14 The second project requires an investment of $150,000. The discounted cash flows from the project are as follows.
Therefore, the profitability index for the second project will be as follows. Profitability Index = Present Value of Future Cash Flows / Initial Investment in the Project Profitability Index = $189,680 / $150,000 Profitability Index = 1.26 Since the second project has a higher profitability index, it will be more feasible for the company to select it. Therefore, Blue Co. must select the second project. What is the importance of Profitability Index?Profitability index is crucial for several reasons. Firstly, it helps in the decision-making process for ranking various investments or projects. Similarly, it focuses on maximizing a company's profits, particularly when it has limited resources. Comparatively, it makes the process of selecting projects with variable investment requirements easier. ConclusionProfitability index is a metric used to calculate a project's profitability. It considers a project's discounted cash flows in relation to the initial investment requirement. Profitability index is more effective if used comparatively. It has various applications for companies and focuses on maximizing profitability with limited resources. Originally Published Here: Formula for Profitability Index What is the Accounting Rate of Return?The Accounting Rate of Return (ARR) represents the average net income that a company expects to generate from an asset from its capital cost. In other words, it is the return that a company expects on an investment in relation to the initial investment cost. The ARR is often applicable in capital budgeting, where companies need to know the returns they can get on their investments. While ARR is a decision-making tool for companies, it is not as prevalent in its usages as other techniques such as Net Present Value or Payback Period. Despite that, it is useful in decision-making as it considers accounting profits. It differs in that aspect from other techniques that use cash flows for decision-making instead. Similarly, ARR does not consider the time value of money, unlike other techniques. What is the Accounting Rate of Return formula?The ARR formula may differ according to the needs of the company that uses it. Usually, the formula that companies use depends on the information they have available at the time. The basic ARR formula is as follows. Accounting Rate of Rate = Annual Profit / Initial Investment Companies may also use the average amount for both parts of the formula. Therefore, companies can also calculate their ARR, using the following formula. Accounting Rate of Return = Average Net Income / Average Capital Cost ExampleA company, Green Co., is considering investing in a project. The project requires an initial investment of $100,000. Green Co. also forecasts that the project will earn revenues of $200,000 while incurring expenses of $180,000. Therefore, the project's Accounting Rate of Return will be as follows. Accounting Rate of Rate = Annual Profit / Initial Investment Accounting Rate of Rate = ($200,000 - $180,000) / $100,000 Accounting Rate of Rate = 0.20 or 20% What are the advantages of the Accounting Rate of Return?ARR has several advantages for companies. Firstly, it is simple to use compared to other capital budgeting techniques. It does not consider the time value of money, which means that the calculations are relatively straightforward. Similarly, it also links with other accounting measures, such as Return on Capital Employed, making it easier to understand. Companies use ARR to compare various projects and the expected returns from those. Therefore, it is crucial in a company's decision-making process. It also considers the accounting returns, making it easier to compare with actual profits from the investment. What are the disadvantages of the Accounting Rate of Return?Compared to other capital budgeting techniques, ARR has several limitations. Firstly, it does not consider the time value of money, which is crucial for decision-making. Instead of using cash flows, it uses profits, which are easily manipulatable. It also ignores various other critical factors, such as working capital changes. The ARR does not calculate the absolute gain on a project. Similarly, it does not provide a definitive investment signal, unlike other techniques such as NPV. Overall, ARR has more disadvantages than benefits. ConclusionAccounting Rate of Return is a metric that shows the average returns from a project based on the capital investment requirements. ARR is a common technique used in capital budgeting. Companies can calculate the ARR of a project using different formulas. ARR has some advantages, but it has more disadvantages due to being basic. Post Source Here: What is the Accounting Rate of Return When companies are performing capital budgeting, they must consider various costs related to the projects. Mostly, these include costs directly associated with the project, such as material and labour. However, it may also consist of some other costs, which may not be as clear. These usually include opportunity and sunk costs. There are some differences between both. What are Sunk Costs?A sunk cost represents money that a company or business has already spent. While in finance, any cost is relevant, in decision-making sunk costs are irrelevant. It is because it represents money spent that the company cannot recover. Similarly, since the company has already paid for it, it does not alter the decisions that a company makes. Sunk costs are in the past and vary from future costs. Therefore, they do not contribute to a company's decisions. Companies usually exclude sunk costs from their decision-making due to this reason. Therefore, identifying sunk costs and differentiating them from others is crucial in decision-making. For companies, sunk costs do not represent relevant costs. For example, a company may have to decide on either using in-house production or outsourcing. If it chooses to use in-house production, it may use its factory building that it has already acquired for $100,000. In that case, the company can make $200,000 from the project. In case it chooses to outsource, it can make a profit of $150,000. Some may think that the second option provides a better return as the company can make $150,000. On the other hand, they may believe the first decision will only make $100,000. It is because it involves using the $100,000 factory, which reduces the benefits of in-house production. However, the factory cost in that example is a sunk cost. Therefore, the $200,000 profit that inhouse production brings does not include any other costs. Since the factory cost of $100,000 is irrelevant to the decision, it does not reduce the profit. If the company could recover the $100,000 factory cost with either decision, it would be relevant to the decision-making process. Overall, sunk costs do not impact the decision-making process. They remain unchanged and do not have any future impact. Therefore, companies ignore sunk costs when measuring their profits from projects or investments. What are Opportunity Costs?Unlike sunk costs, opportunity costs are relevant to the decision-making process. Therefore, companies must calculate these and include them when measuring profits from various projects. However, opportunity costs are not actual costs that companies bear. These represent the profits or benefits that companies miss out on when choosing one course over another. Opportunity costs represent the value that decision-makers lose when choosing between various options. While a single project may have sunk costs, it will never have opportunity costs. It is because the company does not have to choose between two projects. Essentially, whenever companies have to choose between various decisions, they will suffer opportunity costs. For example, a company may choose to invest in a project that provides $100,000 in profits. However, the company must take the resources out of from an existing project that can profit $20,000 in the future. In this decision, the $20,000 relinquished in choosing the first project represents an opportunity cost. ConclusionWhen making decisions, it is crucial for companies to identify relevant costs. Sometimes, however, these costs may not be as clear, like sunk and opportunity costs. Sunk costs represent any money that a company has already spent in is not recoverable. On the other hand, opportunity costs refer to the profits foregone when choosing between several options. Post Source Here: Sunk Cost vs Opportunity Cost |
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