What is Opportunity Cost? Opportunity cost analysis is an important part of a company’s decision-making processes but is not treated as an actual cost in any financial statement. Opportunity cost is The profit lost when one alternative is selected over another. The concept is useful simply as a reminder to examine all reasonable alternatives before making a decision. So, what discusses is – Understand Essay of Opportunity Cost in Managerial Economics.
The Concept of Opportunity Cost is to explain the Meaning, Definition, Principles, Advantages, and Disadvantages.
While the term opportunity cost has its roots in economics, it’s also a very important concept in the investment world. It’s a model that can be applied to our everyday decisions, as we’re faced with making a choice between the many options we encounter each day. For example, you have $1,000,000 and choose to invest it in a product line that will generate a return of 5%. If you could have spent the money on a different investment that would have generated a return of 7%, then the 2% difference between the two alternatives is the foregone opportunity cost of this decision.
Meaning of Opportunity Cost:
Opportunity cost cannot always be fully quantified at the time when a decision is made. Instead, the person making the decision can only roughly estimate the outcomes of various alternatives, which means imperfect knowledge can lead to an opportunity cost that will only become obvious in retrospect. This is a particular concern when there is a high variability of return. The concept of opportunity cost does not always work since it can be too difficult to make a quantitative comparison of two alternatives. It works best when there is a common unit of measure, such as money spent or time used. Opportunity cost is not an accounting concept, and so does not appear in the financial records of an entity.
It is strictly a financial analysis concept. Opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another. While financial reports do not show opportunity cost, business owners can use it to make educated decisions when they have multiple options before them. Because they are unseen by definition, opportunity costs can be overlooked if one is not careful. By understanding the potential missed opportunities one forgoes by choosing one investment over another, better decisions can be made.
Definition of Opportunity Cost:
The Opportunity Cost refers to the expected returns from the second best alternative use of resources that are foregone due to the scarcity of resources such as land, labor, capital, etc. In other words, the opportunity cost is the opportunity lost due to limited resources. It is a very powerful concept when someone has to make a decision to select a particular product or making a choice.
In simple words, opportunity cost means choosing or making the best decision from the different option. When one has to make a decision in between various actions to select only one particular work at a time is called opportunity cost.
When faced with a decision, the opportunity cost is the value assigned to the next best choice. The value or opportunity not chosen by the decision-maker could take many forms, including assets (as a car or home), resources (as land) or even benefits. When companies make decisions to purchase one asset over another, they’re passing up the opportunity cost offered by the asset not chosen.
The Principles of Opportunity Cost:
The opportunity cost of a decision means the sacrifice of alternatives required by that decision. The concept of opportunity cost can be best understood with the help of a few illustrations, which are as follows:
- The funds employed in one’s own business is equal to the interest that could be earned on those funds if they were employed in other ventures.
- The time as an entrepreneur devotes to his own business is equal to the salary he could earn by seeking employment.
- Using a machine to produce one product is equal to the earnings forgone which would have been possible from other products.
- Using a machine that is useless for any other purpose is zero since its use requires no sacrifice of other opportunities.
- If a machine can produce either X or Y, the opportunity cost of producing a given quantity of X is equal to the quantity of Y, which it would have produced. If that machine can produce 10 units of X or 20 units of Y, the opportunity cost of 1 X is equal to 2 Y.
- The opportunity cost of if no information is provided about quantities produced, except about their prices then the opportunity cost can be computed in terms of the ratio of their respective prices, say Px/Py.
- Holding 100 Dollars as cash in hand for one year is equal to the 10% rate of interest, which would have been earned had the money been kept as the fixed deposit in a bank. Thus, it is clear that opportunity costs require the ascertaining of sacrifices. If a decision involves no sacrifice, its opportunity cost is nil.
Opportunity costs are the only relevant costs. The opportunity cost principle may be stated as under: “The cost involved in any decision consists of the sacrifices of alternatives required by that decision. If there are no sacrifices, there is no cost.” Thus in the macro sense, the opportunity cost of more guns in an economy is less butter. That is the expenditure to the national fund for buying armor has cost the nation of losing an opportunity of buying more butter. Similarly, a continued diversion of funds towards defense spending amounts to a heavy tax on alternative spending required for growth and development.
Advantages of Opportunity Cost:
The main advantages of opportunity cost are:
- Awareness of Lost Opportunity: The main benefit of opportunity costs is that it causes you to consider the reality that when selecting among options, you give up something in the option not selected. If you go to a grocery store looking for meat and cheese, but only have enough money for one, you have to consider the opportunity cost of the item you decide not to buy. Recognizing this helps you make more informed and economically sensible decisions that maximize your resources.
- Relative Price: Another important benefit of considering your opportunity cost is it allows you to compare relative prices and the benefits of each alternative. Compare the total value of each option and decide which one offers the best value for your money. For instance, a business with an equipment budget of $100,000 may buy 10 pieces of Equipment A at $10,000 or 20 pieces of Equipment B at $5,000. You could buy some of A and some of B, but relative pricing would mean comparing the value to you of 10 pieces of A versus 20 pieces of B. Assuming you choose 20 pieces of B, you effectively decide this is more valuable to you than 10 pieces of A.
Disadvantages of Opportunity Cost:
The disadvantages of opportunity cost are:
- Time: Opportunity costs take time to calculate and consider. You can make a more informed decision by considering opportunity costs, but managers sometimes have limited time to compare options and make a business decision. In the same way, consumers going to the grocery store with a list and analyzing the potential opportunity costs of every item is exhaustive. Sometimes, you have to make an instinctive decision and evaluate its results later.
- Lack of Accounting: Though useful in decision making, the biggest drawback of opportunity cost is that it is not accounted for by company accounts. Opportunity costs often relate to future events, which makes it very hard to quantify. This is especially true when the opportunity cost is of non-monetary benefit. Companies should consider evaluating projected results for forgone opportunities against actual results for selected options. This is not to generate bad feelings, but to learn how to choose a better opportunity the next time.
The concept of Opportunity Cost:
The concept of opportunity cost occupies a very important place in modern economic analysis. The opportunity costs or alternative costs are the return from the second best use of the firm’s resources which the firm forgoes in order to avail itself of the return from the best use of the resources. To take an example, a farmer who is producing wheat can also produce potatoes with the same factors. Therefore, the opportunity cost of a quintal of wheat is the amount of the output of potatoes given up.
Thus we find that opportunity cost of anything is the next best alternative that could be produced instead by the same factors or by an equivalent group of factors, costing the same amount of money. Two points must be noted in this definition. Firstly, the opportunity cost of anything is only the next best alternative foregone. Secondly, in the above definition is the addition of the qualification or by an equivalent group of factors costing the same amount of money.
The alternative or opportunity cost of a good can be given a monetary value. In order to produce a good, the producer has to employ various factors of production and have to pay them sufficient prices to get their services. These factors have alternative uses. The factor must be paid at least the price they are able to obtain in the alternative uses.
Examples of Opportunity Cost:
Suppose a businessman can buy either a washing machine or a press machine with his limited resources and suppose that he can earn annually $. 40,000 and 60,000 respectively from the two alternatives. A rational businessman will certainly buy a press machine that gives him a higher return. But, in the process of earning $. 60,000 he has foregone the opportunity to earn $. 40,000 annually from the washing machine. Thus, $. 40,000 is his opportunity cost or alternative cost. The difference between actual and opportunity costs is called economic rent or economic rent or economic profit. For example, economic profit from press machine in the above case is $. 60,000 –$. 4000 = $. 20,000. So long as economic profit is above zero, it is rational to invest resources in the press machine.
A company has $2 million to spend on a project. The company can decide to invest the money for advertisement purpose of the particular product at the time of launch in the market. If they decide to invest the money in production and to buy machinery and all then the opportunity cost gets lost for advertisement purpose. And if they decide to spend the money on advertisement purpose, then the opportunity cost will be the organization’s ability to produce the commodity with more efficiently.
Another example for,
A business organization is that an organization owns a building in which it operates its function and so, it does not have to pay any rent for the office room space and all. But from the economist point of view, the business owner might have kept the office space for current use itself or the office space might have given for rent for money. So, that the owner could have earned from the rent but if the owner will not consider or provide the office space for rent then there is a loss in business expenses according to economist viewpoint. But in real life accountant of a business organization cannot provide any loss expenses due to opportunity cost in any accounts.
Even though opportunity cost is not considered by the accountants in case of financial accounts and all. But it is very much important for a manager of the business organization to consider opportunity cost in relation to business strategies. A business manager must consider opportunity cost in calculating the opportunity expenses in the organization for analyzing the profitable deals available in the market. It also helps in utilizing limited resources efficiently.