Opportunity Cost

Definition

Opportunity Cost is the worth of a missed opportunity.

Explanation

Opportunity cost is what you lose by missing an opportunity when you opt for another alternative.

Imagine you have 2 options.

Option A : You can become a gardener and earn a monthly salary of $2000

Option B : You can become an accountant and earn a monthly salary of $3000

Since you can chose only one of the above options (i.e. the options are mutually exclusive), the opportunity cost of becoming a gardener is $3000 per month which represents the income you could have earned had you opted to become an accountant.

Similarly, the opportunity cost of becoming an accountant is the $2000 monthly salary you could have earned had you opted for gardening.

Opportunity cost may be quantitative or qualitative.

Example

Rob is a freelance writer.
He is applying for a writing assignment posted on a freelance website.
The job will take Rob approximately 100 hours to complete.
Rob can earn $10 per hour doing other freelance work.
The assignment is to be completed within a strict deadline of 8 days which means Rob will have to work long hours and will have to miss social gatherings during that time.
Opportunity Cost for Rob of undertaking this assignment is:

• $1,000 that he could have earned by spending the time on other freelance work.
• Missed time with friends and family.
• Peace of mind he would sacrifice by working under a stressful timeline.

Importance

Opportunity Cost is a useful concept that helps organizations to assess not only what they gain by taking a certain decision but also to reflect on what they lose as a result of not selecting a different course of action when scarcity of resources force us to select a single course of action.

Opportunity Cost is not a type of cost that is ordinarily captured in the accounting system such as payroll cost and overheads. It may therefore force organizations to look at the bigger picture when evaluating business decisions.

The concept of opportunity cost is applied in various management accounting areas including:

• Investment appraisal
• Relevant costing
• Linear programming
• Cost of capital
• Make or buy decisions