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The cost of passing up the next best choice while 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.
While the term opportunity cost has its roots in economics, it's also a very important concept in the investment world. It's a model that can be applied to our everyday decisions, as we're faced with making a choice between the many options we encounter each day.
Here we're going to explain the concept of opportunity cost. As part of that explanation, we're going to provide a definition of the term. Next, we'll explain how the term is related to choice and scarcity. Finally, we'll provide several examples that help demonstrate the concept of opportunity cost and how it applies to economics, investing, as well as the business world.
Understanding Opportunity Costs
When faced with a decision, the opportunity cost is the value assigned to the next best choice. The value or opportunity not chosen by the decision-maker could take many forms, including assets (such as a car or home), resources (such as land) or even benefits. When companies make decisions to purchase one asset over another, they're passing up the opportunity cost offered by the asset not chosen.
Scarcity of Resources and Choices
Individually, we're faced with decisions between two or more choices all the time. For example, we might tell a friend we cannot make their party Saturday afternoon because we need to attend our daughter's piano recital. Realistically, we're telling that coworker we're choosing to go to the recital, and passing on the opportunity to attend their party.
We need to make this choice because we cannot be in two places at the same time. Our time is limited and scarce. There isn't enough of it to meet the demands of both options, so we need to make a decision on how to spend it. If going to the party was the next best choice, then the opportunity cost in this example was the fun time we would have at the party.
So a more complete and concise definition of opportunity cost would be:
The value placed on the next-best option, which was not chosen due to the scarcity of a resource.
Opportunity Cost - Business Example
In this last example, a company has $1 million to spend. They could choose to purchase a more efficient machine to make toys, or they could spend the money to market the toy. If they decide to buy the machinery, then the opportunity cost is the lost sales of toys brought in by the advertising campaign. If they decide to spend the money on advertising, then the opportunity cost would be their ability to produce the toy more efficiently.
Assumptions, Limitations, Advantages and Disadvantages of Opportunity Cost
Advantage 1: Awareness of Lost Opportunity
A main benefit of opportunity costs is that it causes you to consider the reality that when selecting among options, you give up something in the option not selected. If you go to a grocery store looking for meat and cheese, but only have enough money for one, you have to consider the opportunity cost of the item you decide not to buy. Recognizing this helps you make more informed and economically sensible decisions that maximize your resources.
Advantage 2: Relative Price
Another important benefit of considering your opportunity cost is it allows you to compare relative prices and the benefits of each alternative. Compare the total value of each option and decide which one offers the best value for your money. For instance, a business with an equipment budget of $100,000 may buy 10 pieces of Equipment A at $10,000 or 20 pieces of Equipment B at $5,000. You could buy some of A and some of B, but relative pricing would mean comparing the value to you of 10 pieces of A versus 20 pieces of B. Assuming you choose 20 pieces of B, you effectively decide this is more valuable to you than 10 pieces of A.
Disadvantage 1: Time
Opportunity costs take time to calculate and consider. You can make a more informed decision by considering opportunity costs, but managers sometimes have limited time to compare options and make a business decision. In the same way, consumers going to the grocery store with a list and analyzing the potential opportunity costs of every item is exhaustive. Sometimes, you have to make an instinctive decision and evaluate its results later.
Disadvantage 2: Lack of Accounting
Though useful in decision making, the biggest drawback of opportunity cost is that it is not accounted for by company accounts. Opportunity costs often relate to future events, notes the Encyclopedia of Business, which makes it very hard to quantify. This is especially true when the opportunity cost is of non-monetary benefit. Companies should consider evaluating projected results for forgone opportunities against actual results for selected options. This is not to generate bad feelings, but to learn how to choose a better opportunity the next time.
There are some difficulties linked while using the opportunity cost strategy as a decision making scheme as it is not usually referred in the management decision making strategy. But some of the new management literature has some coverage in the application cost calculation. Opportunity cost plays a vital part in the decision making system and coverage. Economists have defined opportunity cost differently as per their context, but the main focus was the same and it is concentrating on the profit that is determined by specific resources and different purposes. Opportunity cost is still an important aspect in the decision making of the management.
Decision making system usually overlooked the opportunity cost strategy. Examples of accounting and monetary costs should include books, accommodation fees and tuition fees if assuming a college context. Many opportunity cost examples have been neglected and they are as follows:
Time spent while attending a class could be a working schedule in a company and getting a salary.
Missing of the value of activities in order to get more time for further studies.
The investment in education could be more fruitful rather than purchasing items.
Case Study of Island Life Assurance Co. Ltd
Island Life Assurance Co. Ltd
Island Life is part of the Currimjee Group of companies, a conglomerate that speaks for itself.
Island Life, to date, has 25 years' of experience in the Mauritian market to leverage from. Its product range caters for both individual and corporate clients. On the individual front, its product portfolio includes:
Investment plans with competitive bonuses
Cash back policies every 4/5 years
Pure risk covers (Term policies)
Key main insurance
Secured loans for housing & other purposes
All plans support riders like critical illness, accidental death benefit or waiver of premium, based on customer requirements.
On the corporate front, ILA offers group life assurance as well as pension administration and fund management services.
Island Life Assurance Co. ltd also has the opportunity cost analysis that it follows. Although opportunity costs are not generally considered by accountants-financial statements only include explicit costs, or actual outlays-they should be considered by managers. Most business owners do consider opportunity costs whenever they make a decision about which of two possible actions to take. Small businesses factor in opportunity costs when computing their operating expenses in order to provide a bid or estimate on the price of a job. Opportunity costs increase the cost of doing business, and thus should be recovered whenever possible as a portion of the overhead expense charged to every job.
These economic opportunity cost examples are being provided with a view to clarify any doubts regarding the real life applications and implications of this topic in Island Life Assurance Co. Ltd are as follows:
Island Life Assurance Co. Ltd owns the building in which it operates, and thus pays no rent for office space. But this does not mean that the company's cost for office space is zero, even though the accountant might treat it that way. Instead, the owner must consider the opportunity cost associated with reserving the building for its current use. Perhaps the building could have been rented out to another company, with the business itself relocated to a location with a higher level of customer traffic. The foregone money from these alternative uses of the property is an opportunity cost of using the office space, and thus should be considered in calculations of the business's expenses.
Another example can also be into the administration of the company; the company will take quotation like example for the paper supplies from many suppliers and only where price will be low, orders will be there only. Price was prioritised to quality. Unknowingly, the practice of opportunity cost was being adopted by the employees.
Opportunity Cost Savings
Corporate department management is increasingly recognizing the benefits from optimizing the recruiting process through the corporate Careers site. However, the corporate Careers website is only one component of a broader corporate staffing process. Yet the Careers site is a very public reflection on the corporation, and requires an allocation of corporate resources of labour and budget. While corporate staffing departments are undergoing increased scrutiny and process re-engineering, executive management is simultaneously realizing the impact that external recruiting and internal talent deployment and redeployment practices have on corporate goals. This is especially appreciable with revenue-generating roles such as sales positions. Opportunity cost savings may be easily assessed by calculating the cost to the corporation of an unfilled position over time. Careers site best practices can provide savings and create value by contributing to an effective process which efficiently provides quality talent to the corporation.
Opportunity cost could be the price that going to pay in the future, in another word, we have to make decision among the alternatives. Although it would be enormous to possess all worthy things, but resources are limited, which allow serving one purpose at one time. Market demand is the key factor to help the management to decide which is the best product or service to implement. In addition, the value of choice should have further benefits and cost relatively. For a simple example, play station games and women magazines are two the most demanding productions; due to the economy crisis, company need to decide cutting back one production (though this is the next best value). As Livingstone (2007) wrote that "Effective management decisions require careful comparison of costs and benefits of alternative action". As a result, play station game shows growth potential and less cost compare to magazines. This could be the better production outcome and reduce unnecessary use of resources.
Opportunity cost is the price one will accept to pay in the future when making decisions between several alternative courses of action. In spite of the fact that it would be ideal to engage all opportunities if one had unlimited resources, this is not realistic. In the business, market demand is the vital factor that helps management decide which is the best profitable plan to the organization. This essay states about the effective management decisions which involve careful comparison of costs and advantage of alternative action. For more outcome the company could find other alternative to go with.