Opportunity Costs

Opportunity costs are not recorded in the accounting process, and although they are favoured by economists as appropriate costs for decision making, they are difficult to identify and to measure in practice. Hence, accountants prefer to record and use more objective measures of costs, such as past costs or budgeted future costs as guidelines for decision making. There are a number of decision problems, however, in which the only relevant cost is the opportunity cost. The opportunity cost may be defined as the value of the next best opportunity foregone, or of the net cash inflow lost as a result of preferring one alternative rather than the next best one. In cases where it is clear that only the opportunity cost will assist in making the decision, the accountant is often able to attempt its measurement.

Example

The Nationwide Investment Corporation Ltd seeks to invest £1 million. It has selected two investment projects for consideration: project A which is estimated to produce an annual return of 15 per cent, and project B which is expected to yield 20 per cent annually.

On the basis of these facts, it is clear that the Corporation will select project B. The additional gain resulting from that decision may only be measured in terms of the opportunity costs of sacrificing project A, as follows:

Estimated annual return from project B £200,000

Less: Opportunity cost (the sacrifice of the estimated annual returns from project B) 150,000

Advantage of project B £50,000

The opportunity cost is always a relevant cost concept when the problem facing the firm is a problem of choice: the measure of the cost of the decision is the loss sustained by losing the opportunity of the second best alternative. It is the opportunity cost which must be taken into account in calculating the advantage of choosing one alternative rather than the other.

The use of the opportunity cost concept is illustrated in the following situations:

(a) dropping a product line

(b) selling or further processing a semi-manufactured product

(c) operate or lease

(d) make or buy a product.

Dropping a product line

Invariably the reason for wishing to drop a product line is that it is unprofitable, or it is less profitable than another product line to which the firm could switch resources.

Selling or further processing

On occasions, it is possible for a firm to bring a product to its semi-finished state and then to sell it, rather than proceed to complete the production process and sell the finished article.

Operate or lease

The decision as to whether to operate or lease assets is another example of the importance of opportunity costs for decision making.

Make or buy

It is quite common for firms to subcontract the making of components to specialist firms. This practice does increase their dependence on outside suppliers and reduce to some extent their control on the quality of the components. The opportunity cost approach to this type of decision enables the firm to consider the advantages which could be obtained from alternative uses of the productive capacity released as the result of subcontracting the making of components.

The allocated fixed costs are irrelevant to the decision since they are not affected, and will continue to be incurred by High-performance Motors irrespective of whether the parts are made or bought. Since the relevant costs of making are less than the costs of buying, the firm should reject the offer and continue to make the parts.

Let us now consider the possibility that if the firm accepted the offer, the productive capacity released as a result will not remain idle, and will be used to extend the production line of motor cars. It is calculated that an additional four cars a month could be produced, leading to an increase in profits of £10,000. The opportunity costs of not accepting the offer, therefore, amount to £10,000. Hence, the information which is now relevant to the decision as to making or buying the part is as under:

The introduction of the opportunity cost of not accepting the offer has altered the nature of the decision completely, and reversed the previous conclusion that it was advantageous to make the part.


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Read on: The Importance of the Contribution Margin

The importance of the contribution margin

Usually, short-run tactical decisions are aimed at making the best use of existing facilities. The contribution margin is an important concept in this analysis. It is defined as the excess of the revenue of any activity over its relevant costs, which is available as a contribution towards fixed costs and profits. Profits, of course, will not be made until all fixed costs have been covered, but under certain circumstances the expectation of a contribution margin will be sufficient to justify a particular decision.

One decision problem... see: The Importance of the Contribution Margin