Opportunity Cost

Definition

Opportunity cost is the value of the next best alternative that must be forgone in order to pursue a certain action or decision. It represents the trade-off involved in choosing one option over another and is a fundamental concept in economics and managerial decision-making.

5 Must Know Facts For Your Next Test

1. Opportunity cost is a crucial consideration in evaluating whether to accept or reject a special order, as it represents the potential revenue or contribution margin that would be foregone by accepting the special order.
2. When deciding whether to keep or discontinue a product or segment, opportunity cost analysis helps determine the value that would be lost by discontinuing the offering and the potential benefits of redeploying resources to more profitable alternatives.
3. Opportunity cost is a key factor in the decision to sell a product or process it further, as it represents the potential revenue that could be generated from the alternative use of the resources.
4. In the context of constrained resources, opportunity cost analysis is essential to determine the best allocation of limited resources to maximize overall profitability or achieve other organizational objectives.
5. Opportunity cost is a central concept in capital investment decisions, as it represents the potential returns that could be earned by investing in alternative projects or assets.

Review Questions

• Explain how opportunity cost analysis is used in the decision to accept or reject a special order.
  • When evaluating whether to accept a special order, the opportunity cost represents the potential contribution margin or revenue that would be foregone by accepting the special order instead of selling the product or service through regular channels. The decision-maker must weigh the additional revenue from the special order against the lost contribution from regular sales to determine if the special order is the best use of the company's resources.
• Describe the role of opportunity cost in the decision to keep or discontinue a product or segment.
  • In deciding whether to keep or discontinue a product or segment, opportunity cost analysis is crucial. The opportunity cost represents the potential benefits or profits that would be lost by discontinuing the offering and redeploying the resources elsewhere. Decision-makers must carefully consider the opportunity cost of discontinuation, as it may involve forfeiting future cash flows, market share, or strategic advantages that could be more valuable than the current contribution of the product or segment.
• Evaluate how opportunity cost influences the decision to sell a product or process it further.
  • The decision to sell a product or process it further involves weighing the opportunity cost of each option. The opportunity cost of selling represents the potential additional revenue or profit that could be generated by processing the product further and selling it in a more valuable form. Conversely, the opportunity cost of processing further includes the potential revenue that could be immediately realized by selling the product in its current state. Managers must carefully analyze these opportunity costs, considering factors such as resource constraints, market demand, and the relative profitability of each alternative, to determine the optimal course of action.

Related terms

Sunk Cost: A sunk cost is an expense that has already been incurred and cannot be recovered. Sunk costs should be ignored when making future decisions, as they do not affect the potential benefits or drawbacks of the current alternatives.

Incremental Analysis: Incremental analysis is the process of evaluating the additional costs and benefits associated with a decision. It focuses on the changes in revenues and expenses between alternatives to determine the optimal choice.

Relevant Costs: Relevant costs are the future costs that will be affected by a decision. They are the costs that should be considered when evaluating alternatives, as opposed to sunk or irrelevant costs.