Definition

The cost of passing up the next best choice when making a decision. For example, if

an asset such as capital is used for one purpose, the opportunity cost is the value of the

next best purpose the asset could have been used for. Opportunity cost analysis is an

important part of a company's decision-making processes, but is not treated as an actual

cost in anyfinancial statement.

What is an opportunity cost?

An opportunity cost is quite literally the cost of an opportunity that has been sacrificed for something

else. Individuals, businesses and governments all face opportunity costs in every decision they

make.

For example, say a man wanted to go to the cinema this evening but also wanted to have a BBQ

with his friends. If he went and watched a film in the cinema the opportunity cost to the man would

be the time and enjoyment lost out by not having a BBQ with his friends.

Why is it significant?

Opportunity cost is an important economic concept that is inherent in the decision-making of

individuals, businesses and other entities.

The famous saying that ‘there is no such thing as a free lunch’ is exactly what opportunity cost is all

about. If someone invites you out for a free lunch, is it completely free? Absolutely not. The potential

opportunities that you could be doing whilst having this lunch have been sacrificed – which comes at

a cost – an opportunity cost.

Opportunity cost for individuals

Individuals encounter opportunity costs every day. Should you carry on reading this article instead of

watching your favourite TV programme? In every decision you make you will have weighed up the

benefits of choosing each option and calculated which option will give the lowest opportunity cost.

Opportunity cost is an important concept because it shows why people make certain choices. For

example, if someone chooses to go to university for three years they must think that studying for this

period of time will be worth the opportunity cost of not having a job for three years which provides

paid employment and work experience.

Opportunity cost for businesses

Businesses and corporations are also faced with opportunity costs. If a business decides to invest

£50,000 into a new factory in order to expand its production, there are large opportunity costs

involved. The money could be spent on new equipment in order to increase productivity (the

efficiency of the use of resources). On the other hand, there is also an opportunity cost of not

keeping the money in a bank account where it will collect interest payments.

Businesses also face opportunity costs when deciding to shut down or change a part of its

operations. For example if a retail business wants to move one of its stores from the centre of the

city to the middle of the countryside the opportunity costs will be the lost profits of the store in the

city. If the store in the city made £10,000 a week of profit and the new store in the countryside is

making £15,000 a week profit then you may think that the decision to close the store in the city has

resulted in large benefit of £15,000 a week. However, by not having the store in the city, the

business is no longer making that £10,000 a week so the actual economic profit from this decision is

£5,000 (£15,000 minus £10,000) due to the opportunity cost involved.

Key Terms

Economic costs – These are the costs of a business, individual or government that take into

consideration the opportunity costs involved in an action as well as the tangible costs.

Economic profit – This is profit that is calculated using economic costs i.e. revenue – economic costs

= economic profit.

When economists refer to the “opportunity cost” of a resource, they mean the

value of the next-highest-valued alternative use of that resource. If, for example,

you spend time and money going to a movie, you cannot spend that time at home

reading a book, and you cannot spend the money on something else. If your next-

best alternative to seeing the movie is reading the book, then the opportunity cost

of seeing the movie is the money spent plus the pleasure you forgo by not reading

the book.

The word “opportunity” in “opportunity cost” is actually redundant. The cost of

using something is already the value of the highest-valued alternative use. But as

contract lawyers and airplane pilots know, redundancy can be a virtue. In this case,

its virtue is to remind us that the cost of using a resource arises from the value of

what it could be used for instead.

This simple concept has powerful implications. It implies, for example, that even

when governments subsidize collegeEDUCATION , most students still pay more than

half of the cost. Take a student who annually pays $4,000 in tuition at a state

college. Assume that the government subsidy to the college amounts to $8,000 per

student. It looks as if the cost is $12,000 and the student pays less than half. But

looks can be deceiving. The true cost is $12,000 plus the income the student

forgoes by attending school rather than working. If the student could have earned

$20,000 per year, then the true cost of the year’s schooling is $12,000 plus

$20,000, for a total of $32,000. Of this $32,000 total, the student pays $24,000

($4,000 in tuition plus $20,000 in forgone earnings). In other words, even with a

hefty state subsidy, the student pays 75 percent of the whole cost. This explains

why college students at state universities, even though they may grouse when the

state government raises tuitions by, say, 10 percent, do not desert college in

droves. A 10 percent increase in a $4,000 tuition is only $400, which is less than a 2

percent increase in the student’s overall cost (see HUMAN CAPITAL ).

What about the cost of room and board while attending school? This is not a true

cost of attending school at all because whether or not the student attends school,

the student still has expenses for room and board.

About the Author

David R. Henderson is the editor of this encyclopedia. He is a research fellow with Stanford

University’s Hoover Institution and an associate professor of economics at the Naval

Postgraduate School in Monterey, California. He was formerly a senior economist with President

Ronald Reagan’s Council of Economic Advisers.

Further Reading

Alchian, Armen. “Cost.” In Encyclopedia of the Social Sciences. New York: Macmillan. Vol. 3, pp. 404–

415.

Buchanan, J. M. Cost and Choice. Chicago: Markham. 1969. Republished as Midway Reprint. Chicago:

University of Chicago Press, 1977. Available online

at:http://www.econlib.org/library/Buchanan/buchCv6.html

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http://www.econlib.org/library/Enc/OpportunityCost.html

Definition

Opportunity cost can be defined as the cost of an alternative which must be abstained from so as

to pursue a specific action. In other words, opportunity cost refers to the benefits that could have

been received through an alternative action.

Explaining opportunity cost

As explained by Investopedia, the opportunity cost can be explained through the following

illustration. The opportunity cost of going to college is the amount that could have been earned

through working instead. Where on one hand you miss four years of salary while earning a degree,

on the other hand, you also expect earning much more during your career.

Taking another instance, if a gardener decides to grow potatoes in his field, his/her opportunity cost

would be the alternative crop that could be grown otherwise.

Both the aforesaid cases involve making a choice between the two options. The decision would have

been easier if the end outcome was known.

Significance of opportunity cost

Analyzing the opportunity cost forms an essential part of a business firm’s decision making

processes. Besides, it is an imperative economic concept which finds application in wide ranging

business decisions. Also, opportunity costs are real although they do not appear on the balance

sheet.

The opportunity cost might feature significant value although it doesn’t have a specific monetary

value. Moreover, the decision taking authority must subjectively estimate t6he opportunity costs. The

opportunity costs are difficult to be quantified for being frequently related to future events. However,

opportunity costs are very often overlooked while making decisions. Besides, the opportunity costs

might also include the peace of mind for the investor who has invested in a professionally supervised

fund.

Also, opportunity cost evaluation features various practical business applications, for opportunity

costs will subsist with subsisting resource scarcity. While choosing from different production

possibilities, evaluating the cost of capital, analyzing comparative advantages, and even while

making a choice for the product to buy or how time should be spent, it is highly important to consider

the value of next best alternative.

Therefore, it is essentially important to consider all feasible costs while making economic decisions

rather than considering only those which can be concretely measured in dollars and return rates.  

http://www.readyratios.com/reference/analysis/opportunity_cost.html

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.

SEE ALSO: Balance Sheets   ; Economics   ; Strategic Planning Failure

Dena Waggoner

Revised by Laurie Collier Hillstrom

FURTHER READING:

Internet Center for Management and Business Administration. "Opportunity

Cost." NetMBA.com. Available from

< 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.

Read more: http://www.referenceforbusiness.com/management/Ob-Or/Opportunity-Cost.html#ixzz3XYJzBt70

http://www.referenceforbusiness.com/management/Ob-Or/Opportunity-Cost.html

What it is:

Opportunity cost refers to the value forgone in order to make one particular investment instead of another.

How it works/Example:

For example, let's assume you have $15,000 that you could either invest in Company XYZ stock or puttoward a graduate degree. You choose the stock. The opportunity cost in this situation is the increased lifetime earnings that may have resulted from getting the graduate degree -- that is, you choose to forgo the increase in earnings when you use the money to buy stock instead.

Here's another example. Let's say you have $15,000 and your choice is to either buy shares of Company XYZ or leave the money in a CD that earns only 5% per year. If the Company XYZ stock returns 10%, you've benefited from your decision because the alternative would have been less profitable. However, if Company XYZ returns 2% when you could have had 5% from the CD, then your opportunity cost is (5% - 2% = 3%).

Why it Matters:

Opportunity cost is all about the most basic of economic concepts: trade-offs. It's a notion inherent in almost every decision of daily life and of investing: if you make a choice, you forgo the other options for now. And what's been given up can sometimes turn out to have been the wiser choice, which is why opportunity cost is best measured in hindsight -- after all, it is impossible to know the end outcome of any investment. 

Opportunity costs are a factor not only in consumer decisions, but in production decisions, capitalallocation, time management, and lifestyle choices. 

http://www.investinganswers.com/financial-dictionary/stock-market/opportunity-cost-2560

The whole essence of economics theory is to try to satisfy mans unlimited want through the scarce

means provided by nature. The scarcity of these resources forms the basis of opportunity costs in

economics. Scarcity in resources, results in a need to make tradeoff between different available

opportunities that have to be satisfied using the same means. This implies that scarcity gave birth to

the theories surrounding opportunity costs. The process of fulfilling some wants and desires of

limited resources creates the term choice. All the decision that involves making a choice between

different alternatives has an opportunity cost. The ability to choose among different opportunities will

be based on the opportunity cost or the value of the foregone activity. Choosing one alternative

means that we have to give up the other opportunities. Every choice has an associated cost and the

value that is foregone is the alternative with the highest value. One difference between the

accounting costs of goods or services and opportunity cost is that opportunity cost is the cost of the

next best alternative.

There is also a significant difference between accounting costs and opportunity cost. This can be

illustrated with the example of an employee who wants to quit her job and pursue a masters Degree

in economics that will take three Years. Suppose we assume that the total costs charged for a

masters Degree in that University is $40,000 on tuition, accommodation and project fees. Then the

accounting costs for doing a masters Degree will be $40,000. On the other hand if we also assume

that the employee was receiving a salary of $40,000 per year and there is a policy in the company to

increase the employee’s salary by 5% each year then the opportunity cost of the employees will be.

The salary that the employees ought to have received in the three years plus the accounting costs

for doing the masters. Mathematically the opportunity cost is. $44,100+$40,000+$42,000+

$40,000=$166,100. It is now clear from the example that opportunity costs is higher than Accounting

costs.

An Opportunity cost is one of the useful techniques that are applied in the decision making under

the cost benefits analysis. Opportunity costs can be in monetary or non monetary terms. An example

of the monetary opportunity cost is in the above example. Opportunity cost is usually expressed as a

relative ratio of one choice of an opportunity relative to the other opportunity. Opportunity cost has a

lot of practical applications in real life. One such area of application is making consumer’s choice.

The level of satisfaction of a consumer will be used to judge the best good or service. The second

best good in terms of satisfaction will be the foregone choice. Opportunity costs will also be used to

get the cost of borrowing capital from different sources: issuing ordinary shares; issuing debentures

or borrowing a long term loan. Other area of application will be in analysis of comparative

advantages, Time management, and production possibilities and in junior school to help students do

the best career choices

http://www.whatiseconomics.org/what-is-economics/opportunity-costs