Opportunity cost is commonly defined as the next best alternative. Also, known as the alternative cost, it is the loss of gain which could have been gained if another alternative was chosen. It can also be explained as the loss of benefit due to a change in choice.
Opportunity cost is an economic concept arising out of the realistic assumption of the scarcity of resources. The limited amount of resources will also limit the number of possibilities for production. As the number of possibilities of production is limited, to produce a given combination of goods, the production of another combination of goods would have to be forgotten. This can be referred to as opportunity cost.
Opportunity cost is a concept that is widely used by promoters and business analysts to conduct feasibility studies as well as to ascertain policy decisions to be taken.
Every opportunity cost is due to a faulty decision. The better the decision is, the smaller will be the opportunity cost. An opportunity cost can be found in any daily activity. The homework you did not do could be the opportunity cost of sleeping more. Even though you prefer sleeping, the homework makes you more productive and may fetch you more marks.
In economics, the opportunity cost of decisions generally pertains to the opportunity cost arising due to the decisions of the firm in production. This decision on the choice of production occurs due to the scarcity of resources. For example, a farmer has a fixed area of land in which she cultivates different crops. If the farmer sows rice at a particular time, she can’t produce wheat now as she has already used up his land to produce rice. The gain that the farmer would have earned by cultivating wheat over and above her earnings by sowing rice is her opportunity cost.
This opportunity cost arose due to two main reasons - the limited area of land with the farmer and her decision to sow rice instead of wheat. If the farmer had an unlimited area of land and unlimited units of labour with her, she could have produced any quantity of both rice and wheat. And if she had decided to produce wheat instead of rice she would have earned more than she does now.
Opportunity cost is the extra return on an alternative available over and above the chosen option.
Therefore, Opportunity cost = Return from the best alternative – Return from the already selected option
This calculation of opportunity cost has a wide range of applications. Most prominently being used in product planning decisions, the concept of opportunity cost is relevant in many other business scenarios. The calculation method is used when prices paid to factor services are determined and also to calculate economic rent, which is the difference between the actual return to factor services and their supply price.
The calculation of opportunity cost is not only applicable to the producers. The consumers also use the method of opportunity cost to weigh different consumption bundles among each other.
There are broadly two types of opportunity costs. They are explicit costs and implicit costs.
Explicit costs are as the name suggests direct costs that can be identified clearly. The explicit costs are incurred and recorded in the books of accounts. These explicit costs would have to be paid in cash or kind. For example, if a piece of machinery in the firm malfunctions, the repairing cost is explicit. The repairing and reinstalling work will have to be paid in cash and the transaction is charged in the books of accounts as an expenditure.
Implicit costs are indirect or invisible costs that cannot be directly or easily traced down. The implicit costs affect the firm as the loss of its owned resources. Payments are not usually made as there is no real cost. For example, if in a firm a piece of machinery breaks down as mentioned earlier, in addition to the cost of repairing which is an explicit cost there is also an implicit cost of loss in production. The production in that unit is stalled as the machinery is not working and, in the meantime, other valuable resources like human resources are being wasted.
The concept of increasing opportunity cost is usually seen in the production possibility frontier which shows the possibility of production of different bundles of two goods using a limited amount of resources. The Production Possibility Frontier is concave to the origin and its slope is the opportunity cost. As the PPF is concave to the origin, it shows how the opportunity cost of producing more of one good continuously increases. This increasing nature of opportunity cost is generally explained in terms of the inefficiency of resources when put to work to produce more than one kind of good.
For example, if in an economy, steel can be used for making utensils as well as weapons. As more and more steel is used in the production of weapons and less on utensils, the opportunity cost goes on decreasing. This is because the amount of other resources employed in the production of weapons, namely machinery is fixed and as more and more steel is fed into the limited amount of machinery, it becomes inefficient.
Q1. What is an Opportunity Cost in Accounting?
Ans. Opportunity cost is defined as the worth of a missed alternative opportunity in accounting also. The concept is somewhat the same in economics as well as accounting. The only difference is that the concept of opportunity cost in accounting gives more focus on the calculation or quantitative part. The concept of opportunity helps us in gaining knowledge in what we gain by choosing any alternative and which one should we actually choose. From the accounting point of view, the opportunity cost is applied in Investment appraisal, linear programming, purchasing decisions, and relevant costing.
Q2. What is the Opportunity Cost of Capital?
Ans. The opportunity cost of capital is the additional return on investment that a firm forgoes to use that investment for an internal project, rather than using those funds to invest in marketable securities. Most marketable securities have fixed returns and are safe to invest in. The internal projects are comparatively riskier and also involve a higher amount of effort on the part of the enterprise. So, if the rate of return on a project that the firm wants to embark upon is expected to be lower than the rate of investment in securities, then definitely the project is disadvantageous. The opportunity cost of capital therefore is a very useful concept for business analysis and decision making.