Question

Suppose you decide to open a copy store. You rent store space (signing a 1-year lease to do so), and you take out a loan at a local bank and use the money to purchase 10 copiers. Six months later, a large chain opens a copy store two blocks away from yours. As a result, the revenue you receive from your copy store, while sufficient to cover the wages of your employees and the costs of paper and utilities, doesn't cover all your rent and the interest and repayment costs on the loan you took out to purchase the copiers. Briefly explain whether you should continue operating your business.

Short answer

Whether to continue running the business depends on the current revenue and costs, not on the sunk costs. If the costs that are not being covered by the current revenue are less than the potential earnings that could be gained by using the resources elsewhere (opportunity cost), then it would be better to continue running the business. However, the sunk costs (money spent on lease and copiers) should not influence this decision as they are costs already incurred and cannot be recovered.

Step-by-step solution

Identify the Sunk Costs

The first step is to identify the sunk costs in this problem. Sunk costs are costs that have already been incurred and cannot be recovered. In this case, the sunk costs are the rent for the store lease for a year and the money used to purchase the ten copiers.

Evaluate Current Revenue and Costs

The next step is to evaluate the current financial situation of the business. Look at how much revenue the business is currently generating and what are the current costs that this revenue is able to cover. In this scenario, the revenue is sufficient to cover the wages of the employees and the costs of paper and utilities but not the rent and the interest and repayment of the loan.

Making the Decision

Based on these pieces of information, the decision about whether to continue running the business can be made. If the costs that are not covered by the current revenue (in this case, the rent and the interest and repayment of the loan) are less than the potential income that one could earn by utilizing the resources elsewhere (called 'opportunity cost'), then it would be better to keep the business running and just try to minimize these extra costs.

Consider the Sunk Cost Fallacy

The final step is to remember not to fall into the sunk cost fallacy. Just because money has already been spent on the lease and the copiers (sunk costs) does not mean it is necessary to keep the business running in an attempt to 'recoup' these costs. These are costs that have already been spent and cannot be recovered. The decision needs to be made based on current and future costs and revenues, not past costs.

Key concepts

Understanding Opportunity Cost

Opportunity cost is a key concept in economics that helps in making smarter business decisions.
When we talk about opportunity costs, we're considering what we are giving up when we make a choice. In simpler terms, it's the cost of the next best alternative that you forego when making a decision.

• If you choose Option A, the opportunity cost is the benefits you might have gained from choosing Option B instead.
• In the context of running a business, it's not just about the money invested; it's also about where else that money could have been used to bring in more revenue or benefits.

For instance, if you keep your copy store open, the opportunity cost is whatever profit you could potentially earn by closing it and investing your resources elsewhere.
Understanding opportunity cost can help business owners make more informed and efficient decisions by always asking: Are the resources used in the best possible way?

Avoiding the Sunk Cost Fallacy

The sunk cost fallacy is a common trap where decision-makers hold onto a failing project due to the amount already invested, rather than cutting losses and moving on.
Sunk costs refer to money or resources that have already been spent and cannot be recovered.
It’s crucial to understand that these costs should not influence current or future business decisions.

• Imagine you've spent a large sum on buying equipment and renting space for your store. These are sunk costs because the money is gone and cannot be reclaimed.
• Continuing your business solely based on past investments can lead to further losses if the future prospects are not favorable.

By not focusing on sunk costs, but rather on future opportunities and costs, you can make more rational decisions.
Always aim to make decisions based on future potential, not past expenditures.

Smart Business Decision Making

Making sound business decisions involves evaluating current and future conditions without letting previous investments cloud your judgment.
Here's how you can approach it:

• First, assess the current revenue and costs to determine sustainability. If your current income can't cover all expenses, reconsider your strategy.
• Next, understand the opportunity costs. Are there better alternatives for using your time and resources?
• Finally, avoid the sunk cost fallacy. Don't let the money already spent force your business into making less-than-optimal decisions. Focus on what will work best moving forward.

Business decision-making is a strategic process that relies on objective assessment rather than emotional attachment to previous investments.
By focusing on real potential and opportunities, businesses can navigate challenges effectively and improve their chances of success.