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Opportunity Cost March April

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Feature By Mohamed E. Bayou, Ph.D., Alan Reinstein, CPA, DBA, and Gerald H. Lander, CPA, CFE, DBA

OPPORTUNITY COSTS: A Tool to Make Better Business Decisions Opportunity cost is ubiquitous since all aspects of life involve opportunities. While some recent studies have examined this concept, the opportunity cost concept remains vague. Decision makers often ignore many opportunity costs, as well as sunk and implicit costs in making business decisions. THE CONCEPT OF OPPORTUNITY COST Economists and CPAs often view the opportunity cost concept differently, with the former defining it more broadly to encompass many types of costs, such as implicit costs not economic costs included by the latter. The real economic  costs of production usually exceed the accounting costs of production because economic costs include both explicit accounting costs and opportunity or implicit costs; i.e., the value of the personal resources the owners of a business make available (their labor and capital). Thus, opportunity cost should be recognized and realized when calculating the real (economic) costs, including incremental costs. Companies may only maximize profits when they recognize their real costs. Austrian economists, particularly Ludwig Von Mises and the London School of Economics, developed the opportunity cost theory (Magni, 2009). Describing opportunity cost of an investment as the income foregone if decision makers invest their capital in different economic endeavors, Magni finds that opportunity cost is “income of a foregone opportunity.” Thus, it is a counterfactual  income  income as opposed to the factual  the  factual  income  income received (or to be received) in actual facts” (Magni’s emphasis). Such opportunity costs include both financial and non-financial components; i.e., income forgone and loss of leisure time, respectively. Unlike CPAs, economists include all aspects of cost to derive opportunity costs. Kohler defines cost as “an economic sacrifice occurred in exchange to acquire an object.” While CPAs define cost of an object as a sacrifice of property obtained through  past  transactions, economists define cost of an object as a sacrifice of a potential property obtainable through a future a  future transaction(s)  transaction(s) of a foregone opportunity. Financial accounting does not record opportunity costs in financial records since doing so would violate the cost principle of goods not actually changing 22

“masters.” Accountants consider opportunity cost as a derived concept of the more general concept of cost, while economists consider all costs as opportunity costs.

EXAMPLES OF APPLICATIONS OF ACCOUNTING AND ECONOMIC OPPORTUNITY COSTS Measuring labor costs for various market conditions and types of jobs should consider special labor market characteristics, including such direct factors as income taxes and unemployment insurance compensation, plus such indirect factors as job quality and the nature of the workers’ unemployment. Generally, CPAs would consider only the direct measurable costs, while economists would also consider the indirect factors. Next, resources used to assess healthcare costs should include economic opportunity costs that should consider difficult-to-measure indirect effects, such as costs of patients “waiting” while non-insured folks use scarce emergency rooms (Robinson, 1993), and which CPAs generally do not measure (Dawson, 1994). CPAs need comprehensive, disaggregated data at the individual patient level to measure opportunity costs, and allocating overhead and fixed costs is difficult given the problems of ascertaining the cause and effect relationships between resources and different users. Pharmaceutical product prices also often ignore opportunity costs since retail prices reflect the patent, government regulated profits, and sunk research and development costs of both successful and unsuccessful products. Thus, few studies estimate the opportunity costs of drugs, relying instead on prices. Also, valuing resources when no market exists, such as informal care or patient time costs, requires methods to derive what economists call “shadow prices” – the true social value Today’sCPA | MARCH/APRIL 2014

(or opportunity cost) of non-marketed resources, such as time and informal care. Health accountants and economists often disagree about proper techniques to measure the opportunity cost of time; for example, the best valuation of the opportunity cost of time for working age adults is the wage they are, or could be, making in paid work, varying according to whether the time lost involves lost work or leisure time, or the likelihood of being unemployed. Economists view opportunity costs as inapplicable in situations when decision makers must follow specific alternatives, as when Toyota follows a centralized approach to decision-making regarding major plant infrastructure. Business-unit managers lack autonomy to make such decisions since the decision is imposed in a top-down managerial hierarchy. Knight, an economist, explains that, “where there is no alternative to a given experience, no choice, there is no economic problem, and cost has no meaning.” But, as shown below, such uncontrollable costs can be meaningful for managerial performance purposes. Net opportunity cost is the difference between income of an alternative and the income of the best  alternative (opportunity). Thus, when investors and other decision makers select the best economic alternative (investing capital in Project A or Project B), they should use the net opportunity cost (NOC) concept, as Equation 1 shows. NOCi = Best alternative’s income – Alternative i’ s income (1) where, NOCi = Project i’s net opportunity cost. Hence, if project A has the highest income, B’s and A’s net opportunity costs are: NOC B = Income from project A – Income from project B = IA - IB NOCA = Income from project A – Income from project A = IA – IA = Zero Thus, selecting the best opportunity out of a set of mutually exclusive opportunities entails no net opportunity cost for an investment decision. Opportunity costs also relate to accepting specially ordered projects. For example, if I A= $10 and IB = $8, Project A’s net benefit = Income from Project A – Opportunity Cost (of not investing in IB) = $10 - $8 = $2. Also, Project B’s net benefit = IB – Opportunity Cost (of not investing in Project A) = $8 $10 = $(2). Now, if the firm were offered a special sales order, that would generate a $10 contribution margin [CM] (sales

less variable costs). Accepting the special order uses capacity available to generate $12 of CM for increased production of Product A. The net benefit of accepting the special sales order would thus equal the special order’s CM minus the related opportunity cost = $10 - $12 = ($2). In the short-term, the firm would reject the special order at the proffered price, but it should also consider such other factors as could it sell more units of Product A and the additional selling costs of doing so. The opportunity cost concept focuses on subjective “opportunities,” as decision makers have different opportunities and evaluate differently their attached values. Opportunities can be actual or potential. Actual opportunities are now available for decision makers. Potential opportunities are a product of imagination that may become relevant in such major decisions as committing to a long-term contract, changing one’s location of living, career and marital status. Opportunity cost can either be unconditioned  or conditioned .

UNCONDITIONED OPPORTUNITY COST When decision makers are not currently committed (no sunk cost), opportunity cost is described as “unconditioned.” However, when considering a choice of actions, three issues arise: (1) define all alternative opportunities; (2) measure the best of these alternative opportunities; and (3) measure the gains in selecting the best alternative opportunity instead of the selected choice – which is the opportunity cost (Alden, 2005, p.1). Ignoring the often hidden indirect costs of interest to economists, to illustrate, in purchasing real estate, a decision maker can select among four mutually exclusive alternatives, A-D (see Table 1). After calculating net benefits, the computed gross amounts of each alternative’s opportunity cost are $20,000, $30,000, $40,000 and $50,000 for alternatives A-D, respectively, as shown in Panels A of Table 1. Panel B shows the net opportunity cost of each alternative as the difference between the gross opportunity cost of the best alternative ($50,000 of alternative D as shown in Panel A) and the gross benefits of each alternative. Thus, the net opportunity cost of alternatives A-D are $30,000, $20,000, $10,000 and $0, respectively, which equal the net benefits from Panel A less Alternative D’s gross opportunity costs. continued on next page

Table 1 Unconditioned Opportunity Cost: An Illustration Panel A Gross benefits Costs (assumed equal for simplicity) Net benefits (gross opportunity cost)

Relevant Opportunities A

B

C

D

$90,000 70,000 $20,000

$100,000 70,000 $30,000

$110,000 70,000 $40,000

$120,000 70,000 $50,000

Panel B Best alternative’s net benefits Net benefits (gross opportunity cost) Net opportunity costs Today’sCPA  | MARCH/APRIL 2014

Relevant Opportunities A

B

C

D

$50,000 20,000 $30,000

$50,000 30,000 $20,000

$50,000 40,000 $10,000

$50,000 50,000 $ 0 23

Opportunity Costs continued from page 23

Table 2 Conditioned Opportunity Cost: An Illustration Panel A

Gross benefits Less: Costs (assumed equal for simplicity) Subtotal Less: Uncovered sunk cost of B Net benefits (gross opportunity cost)

Relevant Opportunities

A

(The Current Commitment) B

C

D

$90,000 (70,000) $20,000 (25,000)

$100,000 (70,000) $30,000 0*

$110,000 (70,000) $40,000 (25,000)

$120,000 (70,000) $50,000 (25,000)

($5,000)

$30,000

$15,000

$25,000

*Alternative B is the current commitment, whose related sunk costs are not affected unless the decision makers  switch to another alternative.

Panel B

Relevant Opportunities

A Best alternative’s net benefits Less: Net benefits Net opportunity costs

$30,000 (5,000) $35,000

Decision: Select Alternative D, which has the l east amount of net opportunity cost. Table 1 quantifies all four alternatives’ benefits and costs; the best choice is real estate D, which has the le ast amount of net opportunity cost (i.e., $0). In short, when decision makers do not consider switching from a c urrent existing commitment to a new alternative, opportunity cost is unconditioned and its application is straightforward, as i llustrated in Table 1. CONDITIONED OPPORTUNITY COST

The study next examined the effects of a “currently committed” decision maker, i.e., who has placed sunk costs into the project, who considers switching to a new alternative. The sunk cost of the current commitment “will not be altered as a result of a decision that will change business activity” (Henr y and Burch, 1974). However, many decision makers consider cost recoverability. The organization behavior literature has many studies about escalation of failed commitments (Staw, 1981; Staw and Ross, 1988). Decision makers often are (overly) “committed” to unrecovered parts of sunk cost, and may make switching to a new alternative less preferable, as part of their personal learning curves. Given that the company is now committed to Project B, Table 2 illustrates t his conditioned opportunity concept. Decision: Select Alternative B since it has the least amount of net opportunity cost; that is, maintain the status quo by not replacing real estate B. 24

(The Current Commitment) B

$30,000  30,000 $ 0

C

D

$30,000  15,000 $15,000

$30,000  25,000 $5,000

Per Table 2, the best alternative is B, maintain the status quo and keep alternative B. The recent U.S. cash-for-clunker program illustrates the importance of sunk cost recovery in decision making. This government program paid about $4,500 to transfer ownership of each old car (clunker) to the government to stimulate automobile sales. CNN Money  (March 9, 2010, p. 1) found that 30 percent of polled customers who used this program “had no intentions of buying a new car, but said they bought one because the government program was too good to pass up.” (So, basically, the program was a giveaway to the 70 percent who would have bought a car anyway.) While this credit reduced the cost of a new car, many customers also  viewed the $4,500 as a sufficient recovery of the sunk cost invested in a clunker. This program temporarily strengthened but “cannibalized” future auto sales. When this program ended in August 2009, General Motors, Ford and Chrysler all reported that “September sales were down more than 30 percent from August” (The American, June 29, 2010). In summary, the essential question relevant to a decision making situation is not whether the past commitment can be reversed, but rather, it is how much is recoverable from the sunk cost in this commitment; that is, focus on cost recoverability rather than commitment reversibility.

ISSUES IN USING OPPORTUNITY COST MODELS Transfer prices (TP) apply many different opportunity cost models that a number of company personnel often do not Today’sCPA | MARCH/APRIL 2014

recognize. Holstrum and Sauls denote four commonly used methods to calculate opportunity costs to set transfer prices, average variable cost, full cost, market price, and managementnegotiated prices. While the first three methods often fail to yield goal congruence, the fourth, negotiation, helps to measure the manager’s performance – a function of production and negotiation ability. However, a negotiated transfer price does not always lead to goal congruence, requiring central management to generate data independently and audit division-provided data. Holstrum and Sauls conclude that “when the transfer price is set by central management at the point at which the opportunity cost of the distributing division equals the opportunity cost of the manufacturing division, both divisions will be encouraged to produce that quantity that would be optimal for the firm. Also, Onsi discusses using opportunity costing with decentralized decision making and creating multi-product organizational profit centers, a potential problem in assessing divisional managers’ performance and incentive compensation based on profit. Assuming that MCa (marginal “variable” costs of Division A) = NMRb (net marginal revenue of Division B), the supplying profit center is not motivated to change the relative use of various factors of production in response to changing factor prices, since these favorable effects will pass over to the buying profit center. The profit center selling the final product will be motivated to manipulate its sales by delaying them into next year, if this year is especially profitable, or to increase its production inventory to capitalize more of its overhead, leading to increased profit if it is originally unfavorable. This affects the production of intermediate goods. The corporate level should thus monitor inventory levels (similar to Holstrum and Sauls’ approach) to help prevent this from occurring. Also, buying divisions could commit themselves to purchasing a certain volume. For a fairer profit distribution, profit center A should be given the profit foregone (motivational cost) from producing X1 and selling it to profit center B. Onsi factors in this “motivational cost” to reduce conflicts among profit centers, which Benke et al, call the “lost contribution margin,” also called the opportunity cost. Benke et al. propose a general approach to transfer pricing that shows companies how to determine a transfer price that will promote neoprofit (which is subject to ever changing constraints, business moves toward achieving the maximum profit), and enhanced performance evaluation. They also propose an opportunity cost general rule for transfer pricing, where the transfer price should equal the standard variable cost (SVC) plus the contribution margin per unit given up (CMGU) on the outside sale by the company when a segment sells internally. Thus, relevant costs equal out-of-pocket (i.e., variable) costs plus opportunity costs. The CMGU is the lost contribution (LCM), so the TP = SVC + LCM. The lost contribution margin (opportunity cost) is the difference between the external  market price of the intermediate product and the SVC. Benke et al. suggest that smaller companies may need to apply the general

rule differently than their larger competitors, as when a small company views an oligopolistic market as being perfectly competitive. Next, Feldstein views the social opportunity cost (SOC) of a public investment project as the value to society of the next best alternative use to which the resources employed in the project could have derived, also discussing such rates as the Marginal Rate of Social Productivity of Private Investment, and the Weighted Average Rate of Return. He shows that the correct measure of the social opportunity cost of a public project is the discounted value of the consumption stream that would have occurred had the project not been undertaken. He discounts this present value at the social time preference (STP) rate, a normative rate reflecting the government’s evaluation of the relative desirability of consumption at different points in time. The estimated forgone consumption stream should reflect the source of funds, the productivity of private investment, and the effects of taxation and reinvestment.

APPLYING ACCOUNTING OPPORTUNITY COSTS FOR BUSINESS DECISIONS FOCUS ON FOREGONE PROFITS Assume a company with a huge backlog of orders for a product that uses a critical machine that generates revenues of $1,000 per hour, but incurs incremental costs and expenses of $400, deriving $600 per hour of contribution margin. Also assume that an employee failed to perform a routine maintenance task that caused the machine to shut down for 10 hours, and the repair bill (repairs and maintenance expense costs) to fix the machine was $800. But, the company also lost $6,000 (10 hours x $600 per hour) in operating or pre-tax income. This example derived $6,000 of opportunity cost of lost profits, ignoring the costs of lost or upset customers. However, if the machine were not critical to manufacturing the product or no backlog of orders arose, no foregone profits or opportunity costs would arise (Averkamp, 2011). TRANSFER PRICING EXAMPLES Drury states that the transfer price should equal t he marginal (variable) cost to produce the transferred product or service, plus the opportunity cost of making the transfer. This point is illustrated by adapting Currie’s hypothetical Glass Co example. The illustration uses PlastiCo that has a Molten Plastic Division, whose summary of annual activities appear below. PlastiCo also has a Plastic Bottles Division that needs 20,000 tons of molten plastic per year to manufacture its bottles. This division currently buys all of its molten plastic from an external supplier for $210 per ton; it can continue using its current supplier, or buy its supplies from PlastiCo’s Molten Plastic Division. First, if the Molten Plastic Division could not increase its output above 80,000 tons per year, all products sold to the

Molten Plastic Division Output and sales (all to external customers) 80,000 tons

Selling price $240 per ton

Marginal cost (= variable cost) $130 per ton

Fixed costs $1,480,000 per year

continued on next page

Today’sCPA  | MARCH/APRIL 2014

25

Opportunity Costs continued from page 25

Plastic Bottles Division would reduce external customer sales. Thus, its relevant cost  to produce molten glass = $130 per ton (given), plus the opportunity cost  to make the transfer (= lost contribution from foregoing the sale to the external customer = [$240 selling price - $130 marginal cost] = $110 per ton). Thus, the minimum transfer price  = [Marginal cost incurred up to the point of transfer] + [Opportunity cost of making the transfer] = $130 + $110 = $240 per ton. The Molten Plastic Division also would not want to transfer its product for under $240, which would reduce the division’s profits. The Plastic Bottles Division will not pay more than $210. PlastiCo’s profits will be maximized by not transferring products. If the Molten Plastic Division has the capacity to increase its output above the current level of 80,000 tons per year, but incur no additional fixed costs and retain the $130 per ton of variable costs, and with no other external demand for its product, it could produce some extra molten glass for the Plastic Bottles Division without affecting its external customers. Its new

REFERENCES Alden, Lori, 2005, “Opportunity Cost, A Primer,” retrieved October 8, 2012 from www.econoclass.com/opportunitycost.html, pp. 1-6. Averkamp, Harold, 2011, “Would You Please Help Me Understand Opportunity Cost?” Retrieved November 4, 2012, from http://blog. accountingcoach.com/opportunity-cost. The American, June 29, 2010, “Cash for Clunkers: A Retrospective,” retrieved October 8, 2012, from http://american.com/archive/2010/june-2010/ cash-for-clunkers-a-retrospective. Benke, Ralph L. Jr., James Don Edwards and Alton R. Wheelock, 1982, “Applying an Opportunity Cost General Rule for Transfer Pricing,”  Management Accounting , June, pp. 43-51. Blocher, E. J., D. E. Stout, P. E. Juras and G. Cokins, Cost Management: A Strategic Emphasis, 6th ed. (NY: McGraw-Hill/Irwin, 2013). Burch, Earl E., and William R. Henry, 1974, “Opportunity and Incremental Cost: Attempt to Define in Systems Terms: A Comment,” The Accounting Review, January, pp. 118-123. Byrns, Ralph, 2011, “Accounting vs. Economic Costs,” Economics Interactive, retrieved October 8, 2012 from http://www.unc.edu/depts/econ/ byrns_web/Economicae/Essays/Actg_V_Econ.htm. CNN Money , March 9, 2010, “Cash for Clunkers, Better Than We Thought,” retrieved October 8, 2012 f rom http://money.cnn.com/2010/03/09/autos/ clunkers_analysis/index.htm. Currie, J. 2006. Transfer Pricing . Retrieved November 4, 2012 from http:// www.cpaireland.ie/UserFiles/File/students/Articles/Transfer_Pricing_Article_ by_John_Currie1.pdf. Dawson, D. 1994, “Costs and prices in the internal market: markets  versus the NHS Management Executive guidelines.” York: Centre for Health Economics, University of York, 1994. Drury, C. 2004. Management and cost accounting  (6th ed.). Thomson. Feldstein, Martin S., 1964, “Opportunity Cost Calculations in Cost-Benefit Analysis,” Public Finance, pp. 117-139.

calculations become, first, the relevant  (variable) cost to produce molten glass = $130 per ton; no opportunity costs to make the transfer exists; and t he minimum transfer price equals $130 per ton. The Molten Plastic Division manager can negotiate a price between $130 and $210 per ton to help maximize both divisions’ profits and yield goal congruence for PlastiCo. RECOMMENDATIONS

CPAs, their employers, clients and other decision makers should consider the economic or accounting opportunity cost model to make major decisions, using Excel or other spreadsheet programs. While they both would use similar methodologies to consider sunk costs and to calculate opportunity costs, unlike CPAs, economists would consider the indirect costs of their decisions. They would state that after all, managerial decision making should consider al l relevant ■ economic costs. Holstrum, G. L, and E. H. Sauls, 1973, “The Opportunity Cost Transfer Price,”  Management Accounting   (May): 29-33. Hoskin, Robert E., Spring 1983, “Opportunity Cost and Behavior,” Journal of Accounting Research, pp. 78-95. Jenkins, Glenn 1995. Economic Opportunity Cost Of Labor: A Synthesis, Development Discussion Papers 1995-02, JDI Executive Programs. Knight, Frank Hyneman 1935, The Ricardian Theory of Production and Distribution (Chicago: University of Chicago Press) Kohler, E. L. 1963. “Why Not Retain Historical Cost?” Journal of  Accountancy , 116(4), 35-41. Koopmanschapp, MA, and F. H. Rutten 1996, “A practical guide for calculating indirect costs of disease.” Pharmacoeconomics. 1996; 10: 460–466. Magni, C.A. 2009. “Splitting up value: a critical review of residual income theories.” European Journal of Operational Research (198, 1): 1-22. McRae, T.W., 1970, “Opportunity and Incremental Costs: An Attempt to Define in Systems Terms,” The Accounting Review, April, Vol. 45, No. 2, pp. 315-321. McRae, T.W., 1974, “A Further Note on the Definition of Incremental and Opportunity Cost,” The Accounting Review, January, Vol. 49. No. 1, pp. 124125. Monden, Y., 1993. “Toyota Production System, An Integrated Approach to Just-In-Time.” Second Edition. Industrial Engineering and Management , Press Institute of Industrial Engineers. Onsi, Mohamed, “A Transfer Pricing System Based on Opportunity Cost,” July 1970, The Accounting Review, Vol. 45, No. 3, pp. 535-543. Staw, B. 1981. “The escalation of commitment to a course of action,”  Academy of Management , 6 (October): 577-587. Ross, J. 1988. “Good money after bad,” Psychology Today , 22, 2 February: 30-33. Stiglitz, JE, 1986, Economics of the public sector . New York: Norton; 1986. Robinson R., 1993, Costs and cost-minimization analysis. BMJ.1993; 307: 726–728.

Mohamed E. Bayou, Ph.D., is Professor of Accounting in the College of Business, University of Michigan-Dearborn. He may be reached at [email protected] umd.umich.edu. Alan Reinstein, CPA, DBA, is George R. Husband Professor of Accounting in the School of Business at Wayne State University. He

may be reached at [email protected] Gerald H. Lander, CPA, CFE, DBA, is Gregory, Sharer and Stuart Professor Emeritus at the University of South Florida-St. Petersburg. He may be reached at [email protected] The authors would like to express appreciation to Dave Stout (Youngstown State University) and Phil Beaulieu (University of Calgary). 26

Today’sCPA | MARCH/APRIL 2014

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