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Opportunity Cost

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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.

W

hen 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 nextbest 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 realworld 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 valuemaximizing 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/OpportunityCost.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/opportunitycost-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

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