Business, Legal & Accounting Glossary
A useful concept in evaluating alternate opportunities. If you choose alternative A, you cannot choose B, C, or D. What is the cost or loss of profit of not choosing B, C, or D? This cost or loss of profit is the opportunity cost of alternative A. In personal life, you may buy a car instead of taking a European vacation. The opportunity cost of buying the car is the loss of the enjoyment of the vacation.
Opportunity cost denotes the value that is relinquished by an action that is chosen over the other alternative that is equally desirous. It is, therefore, a cost that is paid for choosing one action over the other. Opportunity cost also refers to the difference in return between the preferred investment and its alternative that was left out.
For example, on an investment in government bonds for a year, the investor receives a paltry return of 3%. To invest in government bonds, the investor gave up the opportunity of investing in mutual funds that would yield 6% per annum. Therefore, the opportunity cost of the investor is 3% (6% – 3%).
Opportunity cost is often used to calculate the cost and benefit of choices. In economics, it is often described as the relationship between choice and scarcity. Opportunity cost is primarily expressed in non-monetary terms.
In the case of opportunity cost, “resources” and “value” go far beyond money to include time, pleasure, and anything else that is both scarce and significant to the person choosing and to the community affected by the choice.
So, for example, if you want to watch two different movies in the theater, the opportunity cost of watching one would be the enjoyment you would get from watching the other. The opportunity cost of earning a graduate degree might be the money you didn’t earn during the time you were in school. The opportunity cost to a city of building a stadium might be the lack of funds to renovate the community center. The opportunity cost of investing in a given stock might be the guaranteed interest and limited risk in Treasury bills.
Opportunity cost is different from accounting cost, which is another economic term frequently used. Opportunity cost is used to deduce the true cost of the chosen course of action. Frequently, the opportunity cost is concealed through the illusion that the chosen course of action has no benefits. This is the implicit hidden cost or the unseen opportunity cost.
Opportunity cost has different interpretations. The most common of all is that it is the cost that needs to be given up to perform an action that is preferred over the next best option. Alternatively, the opportunity cost is the benefit that could have been derived by pursuing the best possible alternative.
If a certain amount of capital asset is employed for a business operation, then the opportunity cost is the value that one could have been obtained by using that capital in the best alternative action.
Relative price is used to express the opportunity cost of performing a certain action. It is represented as the price of a commodity or service relative to that of the next best choice.
Transfer earning describes the wage that labour could have earned from being involved in an alternative profession.
Hurdle rate
Discount rate
Risk free rate
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 any financial statement.
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This glossary post was last updated: 22nd November, 2021 | 0 Views.