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Opportunity Cost

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Simply stated, an opportunity cost is the cost of a missed opportunity. It is the opposite of the benefit that would have been gained had an action, not taken, been taken—the missed opportunity. This is a concept used in economics. Applied to a business decision, the opportunity cost might refer to the profit a company could have earned from its capital, equipment, and real estate if these assets had been used in a different way. The concept of opportunity cost may be applied to many different situations. It should be considered whenever circumstances are such that scarcity necessitates the election of one option over another. Opportunity cost is usually defined in terms of money, but it may also be considered in terms of time, person-hours, mechanical output, or any other finite resource.

Although opportunity costs are not generally considered by accountants—financial statements only include explicit costs, or actual outlays—they should be considered by managers. Most business owners do consider opportunity costs whenever they make a decision about which of two possible actions to take. Small businesses factor in opportunity costs when computing their operating expenses in order to provide a bid or estimate on the price of a job. For example, a landscaping firm may be bidding on two jobs each of which will use half of its equipment during a particular period of time. As a result, they will forgo other job opportunities some of which may be large and potentially profitable. Opportunity costs increase the cost of doing business, and thus should be recovered whenever possible as a portion of the overhead expense charged to every job.

EXAMPLES OF OPPORTUNITY COSTS

One way to demonstrate the concept of opportunity costs is through an example of investment capital. A private investor purchases $10,000 in a certain security, such as shares in a corporation, and after one year the investment has appreciated in value to $10,500. The investor's return is 5 percent. The investor considers other ways the $10,000 could have been invested, and discovers a bank certificate with an annual yield of 6 percent and a government bond that carries an annual yield of 7.5 percent. After a year, the bank certificate would have appreciated in value to $10,600, and the government bond would have appreciated to $10,750. The opportunity cost of purchasing shares is $100 relative to the bank certificate, and $250 relative to the government bond. The investor's decision to purchase shares with a 5 percent return comes at the cost of a lost opportunity to earn 6 or 7.5 percent.

Expressed in terms of time, consider a commuter who chooses to drive to work, rather than using public transportation. Because of heavy traffic and a lack of parking, it takes the commuter 90 minutes to get to work. If the same commute on public transportation would have taken only 40 minutes, the opportunity cost of driving would be 50 minutes. The commuter might naturally have chosen driving over public transportation because she had a use for the car after work or because she could not have anticipated traffic delays in driving. Experience can create a basis for future decisions, and the commuter may be less inclined to drive next time, knowing the consequences of traffic congestion.

In another example, a small business owns the building in which it operates, and thus pays no rent for office space. But this does not mean that the company's cost for office space is zero, even though an accountant might treat it that way. Instead, the small business owner must consider the opportunity cost associated with reserving the building for its current use. Perhaps the building could have been rented out to another company, with the business itself relocated to a location with a higher level of customer traffic. The foregone money from these alternative uses of the property is an opportunity cost of using the office space, and thus should be considered in calculations of the small business's expenses.

BIBLIOGRAPHY

Anderson, David Ray, Dennis J. Sweeney, and Thomas Arthur Williams. Statistics for Business and Economics. Thomson South-Western, 6 January 2004.

Blinder, Alan S., and William J. Baumol. Microeconomics: Principles and Policy. Thomson South-Western, June 2005.

Ernest, Robert Hall, and Marc Lieberman. Microeconomics. Thomson South-Western, 2004.

Vera-Munoz, Sandra C. "The Effects of Accounting Knowledge and Context on the Omission of Opportunity Costs in Resource Allocation Decisions." Accounting Review. January 1998.





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