# Opportunity Cost

## Opportunity Cost (Encyclopedia of Business and Finance)

One of the lamentable facts of life is that nobody can have everything that he or she wants. This is due, in part, to scarce resources. Whether a teenager with a part-time job or a wealthy business-person, no single person owns all of the money in the world. Furthermore, there are only twenty-four hours in a day, and seven days in a week. Time and money are only two of the many resources that are scarce in day-to-day living.

Unfortunately, because of these limits, individuals have to make choices in using scarce resources. One can use his or her time to work, play, sleep, or pursue other options. Or, one can select some combination of possible activities. People can't spend twenty-four hours a day working, twenty-four hours a day playing, and twenty-four hours a day sleeping. People can choose to spend their salary on a nice house, an expensive vacation, or on a yacht, but they probably can't afford all three. They must make choices with their limited resources of money.

In making choices for using limited resources, it is reasonable to evaluate the costs and benefits of all possible options. For instance, suppose one has been trying to decide how to spend the next few years of one's life. He or she has narrowed the options down to two: (1) working at a full-time job, or (2) becoming a full-time student. Going to school will cost approximately \$12,000 per year in tuition, books, and room and board at the local state university for the next four years. In addition, he or she will forego the salary of a full-time job, which is \$24,000 per year. This makes the total cost of going to school \$36,000 per year. In return he or she gets the pleasure, social interaction, and personal fulfillment associated with gaining an education, as well as the expectation of an increase in salary through the remainder of his or her work life.

The question that must be answer is, "do the benefits of education outweigh the costs?" If they do, school should be selected. If the costs are greater than the benefits, the full-time job should be kept.

An "opportunity cost" is the value of the next-best alternative. That is, it is the value of the option that wasn't selected. In the example, if the person had chosen to keep your job, then the opportunity cost is the benefit of going to school, including the intangible benefits of pleasure, social interaction, and personal fulfillment as well as the tangible benefit of an increased future salary for their remaining working life. If the person had chosen to go to school, then the opportunity cost is the \$24,000 per year that would have been earned at the full-time job.

One way of visualizing this concept is through the use of a production possibilities curve graph that relates the tradeoff between two possible choices, or some combination of the possibilities. Consider a very simple possible economy for a country. This country can produce two goods: guns (i.e., defense) or butter (i.e., consumer goods). If this country has historically used all of its resources to produce guns then it may be willing to consider allocating some of its resources to the production of butter. Initially, the resources that are least effective in producing guns (e.g., farmland) will be reallocated to the production of butter. Thus, the country doesn't forfeit many guns to produce a relatively large amount of butter. However, as the country reallocates more resources to the production of butter they are decreasingly productive. At the extreme, when the country gives up the last of its production of guns, the resource is very good for producing guns and not very useful in the production of butter (e.g., a high-tech armaments production facility). Figure 1 demonstrates this situation graphically in showing an example of the production possibilities curve.

In Figure 1, everything on the curved line or in the gray area is a possible production combination of guns and butter in the simple economy. Any combination on the line uses all of the available resources, while any combination in the gray area is considered inefficient since it does not use all of the available resources. Any combination in the white area is impossible to achieve, given the country's resource limitations.

The idea that the country will initially reallocate its least productive resource to the production of the other good is known as the law of increasing opportunity cost. Thus, if the production of the initial ton of butter costs five hundred guns, then the next ton of butter, which uses resources that are better at producing guns, will cost more guns. The next ton of butter will cost still more guns, and so on. This is represented in Figure 1 by the changing slope of the production possibilities curve.

SUMMARY

Because resources are limited, choices must be made. When evaluating choices in this decision making process, one attempts to select the best option; that is, one selects the option that offers the most benefit for the costs incurred, and which are possible given any constraints. This is true for individuals, businesses, or countries, though the decisions that each entity makes are vastly different. The second best option is called the opportunity cost and is what is given up when decisions are made.

## Opportunity Cost (Encyclopedia of Management)

An opportunity cost is defined as the value of a forgone activity or alternative when another item or activity is chosen. Opportunity cost comes into play in any decision that involves a tradeoff between two or more options. It is expressed as the relative cost of one alternative in terms of the next-best alternative. Opportunity cost is an important economic concept that finds application in a wide range of business decisions.

Opportunity costs are often overlooked in decision making. For example, to define the costs of a college education, a student would probably include such costs as tuition, housing, and books. These expenses are examples of accounting or monetary costs of college, but they by no means provide an all-inclusive list of costs. There are many opportunity costs that have been ignored: (1) wages that could have been earned during the time spent attending class, (2) the value of four years' job experience given up to go to school, (3) the value of any activities missed in order to allocate time to studying, and (4) the value of items that could have purchased with tuition money or the interest the money could have earned over four years.

These opportunity costs may have significant value even though they may not have a specific monetary value. The decision maker must often subjectively estimate Opportunity costs. If all options were purely financial, the value of all costs would be concrete, such as in the example of a mutual fund investment. If a person invests \$10,000 in Mutual Fund ABC for one year, then he forgoes the returns that could have been made on that same \$10,000 if it was placed in stock XYZ. If returns were expected to be 17 percent on the stock, then the investor has an opportunity cost of \$1,700. The mutual fund may only expect returns of 10 percent (\$1,000), so the difference between the two is \$700.

This seems easy to evaluate, but what is actually the opportunity cost of placing the money into stock XYZ? The opportunity cost may also include the peace of mind for the investor having his money invested in a professionally managed fund or the sleep lost after watching his stock fall 15 percent in the first market correction while the mutual fund's losses were minimal. The values of these aspects of opportunity cost are not so easy to quantify. It should also be noted that an alternative is only an opportunity cost if it is a realistic option at that time. If it is not a feasible option, it is not an opportunity cost.

Opportunity-cost evaluation has many practical business applications, because opportunity costs will exist as long as resource scarcity exists. The value of the next-best alternative should be considered when choosing among production possibilities, calculating the cost of capital, analyzing comparative advantages, and even choosing which product to buy or how to spend time. According to Kroll, there are numerous real-world lessons about opportunity costs that managers should learn:

1. Even though they do not appear on a balance sheet or income statement, opportunity costs are real. By choosing between two courses of action, you assume the cost of the option not taken.
2. Because opportunity costs frequently relate to future events, they are often difficult to quantify.
3. Most people will overlook opportunity costs.

Because most finance managers operate on a set budget with predetermined targets, many businesses easily pass over opportunities for growth. Most financial decisions are made without the consultation of operational managers. As a result, operational managers are often convinced by finance departments to avoid pursuing value-maximizing opportunities, assuming that the budget simply will not allow it. Instead, workers slave to achieve target production goals and avoid any changes that might hurt their short-term performance, for which they may be continually evaluated.

People incur opportunity costs with every decision that is made. When you decided to read this article, you gave up all other uses of this time. You may have given up a few minutes of your favorite television program or a phone call to a friend, or you may have even forgone the opportunity to invest or earn money. All possible costs should be considered when making financial or economic decisions, not simply those that can be concretely measured in terms of dollars or rates of return.

Internet Center for Management and Business Administration. "Opportunity Cost." NetMBA.com. Available from <<a href="http://www.netmba.com/econ/micro/cost/opportunity">http://www.netmba.com/econ/micro/cost/opportunity>

Kroll, Karen. "Costly Omission." Industry Week, 6 July 1998, 20.

"Opportunities Lost Because 'There Isn't the Budget'?" Management Accounting, June 1998, 7.

Sikora, Martin. "Trying to Recoup the Cost of Lost Opportunities." Mergers and Acquisitions Journal, March 2000.

## Opportunity Cost (Encyclopedia of Small Business)

Simply stated, an opportunity cost is the cost of a missed opportunity. Applied to a business decision, 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, limited resource.

Although opportunity costs are not generally considered by accountantsinancial statements only include explicit costs, or actual outlayshey should be considered by managers. Small business owners should factor in opportunity costs when computing their operating expenses in order to provide a bid or estimate on the price of a job. Opportunity costs increase the cost of doing business, and thus should be recovered as a portion of the overhead expense charged to every job. Ignoring opportunity costs may lead small business owners to undercharge for their services and overestimate their profits.

EXAMPLES OF OPPORTUNITY COSTS

One way to demonstrate opportunity cost lies in the employment of investment capital. For example, 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 5percent. 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 7.5percent. 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 5percent 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 he could not have anticipated traffic delays in driving. Once the choice has been made to drive, it is not possible to change one's mind, thus the choice itself becomes irrelevant. Experience can create a basis for future decisions, however: 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.

Baumol, William J., and Alan S. Blinder. Economics, Principles and Policy. Harcourt Brace Jovanovich, 1982.

Miller, Bruce L., and A.G. Buckman. "Cost Allocation and Opportunity Costs." Management Science. May 1987.

Primeaux, Patrick, and John Stieber. "Managing Business Ethics and Opportunity Costs." Journal of Business Ethics. June 1997.

Sandoval-Chavez, Diego A., and Mario G. Beruvides. "Using Opportunity Costs to Determine the Cost of Quality: A Case Study in a Continuous-Process Industry." Engineering Economist. Winter 1998.

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.

## Opportunity Cost (Encyclopedia of Business)

Simply stated, an opportunity cost is the cost of a missed opportunity. Applied to a business decision, 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, personhours, mechanical output, or any other finite, limited resource.

Although opportunity costs are not generally considered by accountantsinancial statements include only explicit costs, or actual outlayshey should be considered by managers. Business managers should factor in opportunity costs when computing their operating expenses in order to provide a bid or estimate on the price of a job. Opportunity costs increase the cost of doing business, and thus should be recovered as a portion of the overhead expense charged to every job. Ignoring opportunity costs may lead managers to undercharge for their services and overestimate their profits.

EXAMPLES OF OPPORTUNITY COSTS

One way to demonstrate opportunity cost lies in the employment of investment capital. For example, 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 he could not have anticipated traffic delays in driving. Once the choice has been made to drive, it is not possible to change one's mind, thus the choice itself becomes irrelevant. Experience can create a basis for future decisions, however: the commuter may be less inclined to drive next time, now knowing the consequences of traffic congestion.

In another example, a 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 business owner must consider the opportunity cost associated with reserving the building for its current use. Perhaps the building could have beei rented out to another company, or demolished in order to make room for a strip mall. 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 business's expenses.

[John Simley,

updated by Laurie Collier Hillstrom]