Opportunity Cost

What Does Something Cost?

In economics, the core idea is that the cost of something is what has to be given up in order to get it. Everything requires choices to be made.

Opportunity cost emphasizes what has been given up in order to receive whatever one has received.

Nothing in an economy Opens in new window comes without an associated cost.

Using the resources of an organization, whether the resource is cash, inventory, buildings, or employee time, is a cost to the organization.

It is a cost to the organization because once the resource is used for one purpose, it cannot be used for another.
Cost is defined as the use of resources. The measurement of costs is based on the forgone opportunities of using those resources for other purposes.

The magnitude of the forgone opportunity of using a resource is the opportunity cost.

We use opportunity costs to make decisions every day.

For example, the opportunity cost of accepting a job is forgoing the opportunity to do something else with our time.

Another example is the opportunity cost of attending an early-morning class. The forgone opportunity is being able to sleep longer into the early morning.

Also, the opportunity cost of taking in a movie is the forgone opportunity of using the time and money for another activity.

In each case, a decision to use a resource prevents the resource from being used for another purpose.

The concept of opportunity cost is consistent with cost-benefit analysis Opens in new window.

Opportunity costs provide a means of measuring the cost of a particular decision.

The costs of each alternative decision should be identified and measured in terms of the forgone opportunity of using the resources for other purposes.

Measuring Opportunity Costs

The forgone opportunity of using a resource is the opportunity cost to an organization.

  • If a decision involves the use of many different resources, the opportunity cost of using each resource should be measured in monetary terms.
  • The opportunity cost of using each resource is then added and the total opportunity costs are compared with the benefits derived from the decision.

Cash is an organizational resource that is frequently expended to perform different activities. Cash is used to purchase materials, hire employees, and pay utility bills.

Any proposed activity that requires the outlay of cash is incurring an opportunity cost, since cash can be used for many other purposes.

The measurement of the opportunity cost of using cash in the short run, however, is simply the face value of the cash expended.

For example, if a proposed marketing activity requires the purchase of $2,000 of promotional items, the opportunity cost would be $2000.

Measuring the opportunity cost of using non-cash resources is slightly more complicated.

To measure the opportunity cost, the next best use of the resource should be identified. Forgone opportunities of using a resource include selling the resource or using it for another activity.

Generally, however, a similar resource can be purchased, so the use of the resource does not necessarily prevent the other activities from occurring. For example, raw materials can be replaced with further purchases, additional machines and buildings can be bought, and more employees can be hired.

If the next best use of the resource is to sell it, the sales price of the resource is the opportunity cost of using the resource.

For example, suppose you are debating whether or not to keep a particular book as a reference after the course is over. The opportunity cost of keeping the book is the re-sale price you would receive at a used bookstore.

If the use of the resource means that additional resources must be purchased for other activities, the cost of replacing the resources is the opportunity cost.

For a new-car dealership, the forgone opportunity of selling a car is the inability to sell the same car to another customer.

But the dealership can buy another car from the manufacturer or from another dealer. Therefore, the opportunity cost of selling a new car is the cost to acquire an identical vehicle.

In general, the opportunity cost of using a non-cash resource is either its sales price or its replacement cost.

Under the unusual circumstances where a resource cannot be replaced and is critical for another activity, then the loss in organizational value of not being able to perform the other activity is the opportunity cost.

For example, the time of an employee who has specialized knowledge of the organization’s information technology system is limited.

This knowledge cannot be easily replaced by hiring another employee. If the employee has no free time, assigning the employee to perform routine network upgrades and maintenance prevents her from performing some other activity, such as evaluating system security.

The opportunity cost to the organization of using the employee’s time for one activity is the loss in value caused by not being able to undertake the other.

The following numerical examples illustrate the identification and measurement of opportunity costs.

Numerical Example 1

Doris Wheaton has 10 bags of cement in her garage. The bags cost $4 per bag last year when they were purchased. The store now sells the cement for $5 per bag but does not take returns.

A neighbor, however, told Doris he would buy the cement from her for $3 per bag if she did not want them. Doris is considering using the cement to make a patio.

  1. If Doris uses the 10 bags of cement to make her patio and has no other use for the cement, what is the opportunity cost of using the cement?
  2. If Doris must also rebuild her front steps (which requires 20 bags of cement), what is the opportunity cost of her existing 10 bags of cement?

Solution

  1. If Doris has no other use of the cement, the next best alternative to using it for the patio is to sell the cement. She can sell the cement to her neighbor for $3 per bag for 10 bags, or $30. Therefore, the opportunity cost of using the cement is $30.
  2. Using the cement for the patio means that the cement must be replaced to make the front steps. The replacement cost of $5 per bag for 10 bags, or $50, is the opportunity cost of using the 10 bags of cement for the patio.

Numerical Example 2

Clean Copy Center hired a permanent employee to operate a copy machine for large jobs. The permanent employee is paid $14 per hour whether or not copy jobs must be performed. Temporary help can be hired for $16 per hour.

  1. What is the opportunity cost per hour of using the permanent employee to copy a job if there is no other work for the employee to perform?
  2. What is the opportunity cost per hour of using the permanent employee if the employee could be working on another copy job that would generate a value of $12 per hour of work?
  3. What is the opportunity cost per hour of using the permanent employee if the employee could be working on another copy job that would generate a value of $20 per hour of work?

Solution

  1. If there is no alternative use of the employee’s time, the opportunity cost of using the employee is $0 per hour.
  2. The cost of hiring a temporary employee ($16/hour) is greater than the increased value of performing the other work ($12/hour). Therefore, the organization will not hire the temporary employee.

    Using the permanent employee prevents the employee from performing the other work and generating a value of $12 per hour. Under these circumstances, the opportunity cost of using the employee is $12 per hour.
  3. The cost of hiring a temporary employee ($16/hour) is less than the increased value of performing the other work ($20/hour). Therefore, the organization will hire the temporary employee if the permanent employee does not have time.

    Using the permanent employee on another activity causes the copy center to hire a temporary employee. The opportunity cost of using the permanent employee is the cost of hiring a temporary employee, or $16 per hour.

Numerical Example 3

An importer rents a building for storage. The rental cost is $2,000 per month. Presently, the importer occupies only half of the building space. She could sublet the remaining space for $600 per month. She is considering a new line of products to import that would use the remaining space. What is the opportunity cost of using the building to add the new line of products?

Solution

The opportunity cost is the forgone opportunity to sublet the remaining space, or $600 per month.

Numerical Example 4

Your firm registered the Internet web domain name (URL) www.uniwork.org and has signed up with a reliable web-hosting service. For $100 per year, your firm has the exclusive right to use this URL.

You plan to use the website to post job openings for recent university graduates. You expect this business to generate revenues of $60,000 per year, and expenses of $15,000 per year. Before starting the business, another company offers to buy your website URL and service for $55,000 per year.

  1. What ‘cost’ does the accounting system assign to the website URL and hosting service?
  2. What is the opportunity cost of the URL?

Solution

  1. The accounting system assigns a cost of $100 per year to the website URL.
  2. If you start the business, the opportunity cost of the URL is the $55,000 you forgo by not selling it.

The identification and measurement of opportunity cost may appear cumbersome and difficult, but opportunity costs are the appropriate costs for making planning decisions.

In most cases, the opportunity cost of using a resource is either the purchase price or selling price of the resource being used.

In a competitive market with full information and no other costs of buying and selling such as transportation costs, purchase and selling prices converge to the market price or value of the resource.

Therefore, the market price of a resource is a reasonable approximation of the opportunity cost of using the resource. The next post describes sunk or historical costs, which are generally poorer approximation of opportunity cost.