- Other Category:Accounting
Opportunity Costs Definition
In economics, opportunity costs refer to the value of the next-best alternative use of that resource given limited resources. They are applicable beyond finance and accounting. In daily life, opportunity costs are the benefits or pleasures foregone by choosing one alternative over another.
For instance, if you decide to spend money eating out for dinner in a restaurant, then you forgo the opportunity to eat a home-cooked meal. You also lose the opportunity of spending that money on another purchase. If the next-best alternative to eating out is eating at home, then the opportunity cost of eating out is the money spent. In addition, another opportunity cost is the experience you forgo by not eating a home-cooked meal. In other words, the opportunity cost is the value of the next best use of your resources. When resources are scarce, consider the cost between alternatives. Do this so that resources (such as time, money, and energy) are used as efficiently as possible.
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Opportunity Costs for Production
Opportunity costs apply to allocating resources in production. In economics, the production possibility frontier (PPF) refers to the point of allocating resources and producing goods and services in the most efficient way possible. If the economy produces quantities of goods below or above the PPF, then infer that resources are being allocated inefficiently. The PPF illustrates that opportunity costs exist when deciding what quantity of goods and services to produce in order to maximize efficiency and production capacity. Companies use opportunity costs in production to make smart decisions by weighing the sacrifices of choosing one alternative over another.
Explicit costs are opportunity costs when producers make direct payments for expenses such as salaries and wages of employees, rent and utility expenses, and material costs. For example, a company has a $10,000 rent expense. The opportunity cost of $10,000 could have been spent on other aspects of business operations.
Implicit costs are opportunity costs when you use an asset instead of selling or renting the asset to someone else. These opportunity costs exist without any actual payments. Economic profit takes implicit costs into account as an extra opportunity cost when you subtract both explicit and implicit costs from total revenues. Accounting profit only takes explicit costs into account when subtracting explicit costs from total revenues.
Opportunity Costs for Consumption
For example, a homeowner decides to use his guest quarters over the garage to create a home office. The opportunity cost of the homeowner’s decision is either:
- the loss of that guest quarters space for visiting family or friends
- the potential money earned from renting out the space
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Opportunity cost is the benefit you forego in choosing one course of action over another. You can determine the opportunity cost of choosing one investment option over another by using the following formula: Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue.What is opportunity cost in strategic cost management? ›
Opportunity cost (also known as “alternative cost,”) is the difference between a project's cost estimate and another option that must be foregone in order to implement the project. Every choice we make also means giving up another option.What is opportunity cost examples and answers? ›
A student spends three hours and $20 at the movies the night before an exam. The opportunity cost is time spent studying and that money to spend on something else. A farmer chooses to plant wheat; the opportunity cost is planting a different crop, or an alternate use of the resources (land and farm equipment).What are the opportunity costs of going out to eat vs preparing food at home? ›
If the next-best alternative to eating out is eating at home, then the opportunity cost of eating out is the money spent. In addition, another opportunity cost is the experience you forgo by not eating a home-cooked meal. In other words, the opportunity cost is the value of the next best use of your resources.Which is the most correct answer that defines opportunity cost? ›
An opportunity cost is the cost of not being able to do other things with time and resources because of doing the chosen activity.What are the three examples of opportunity cost? ›
- Someone gives up going to see a movie to study for a test in order to get a good grade. ...
- At the ice cream parlor, you have to choose between rocky road and strawberry. ...
- A player attends baseball training to be a better player instead of taking a vacation.
Assume that, given $20,000 of available funds, a business must choose between investing funds in securities or using it to purchase new machinery. No matter which option the business chooses, the potential profit that it gives up by not investing in the other option is the opportunity cost.What is a real life example of opportunity cost? ›
Consider the following examples of opportunity cost: A young woman wants to spend her time either working as a financial advisor or volunteering for a non-profit. She decides to volunteer. The opportunity cost of her choice is the money she would have made working.What are examples of opportunity cost in project management? ›
For example, if Project X has a potential return of $25,000 and Project Y has a potential return of $20,000, then selecting Project X for completion over Project Y will result in an opportunity cost of $20,000. That is the “loss” of not completing Project Y.What are 5 examples of opportunities? ›
- Get help on projects.
- Propose working groups.
- Get testers for new ideas or products.
- Create a team to work on an idea you have.
- Share your expertise or best practices in a particular field.
For instance, if you decide to purchase a new car with your savings, the opportunity cost would be giving up the chance to invest that money into something else such as stocks or real estate. Another example is when a business decides whether to produce goods domestically or outsource production overseas.What is another word for opportunity cost? ›
Implicit costs (also referred to as implied, imputed or notional costs) are the opportunity costs of utilising resources owned by the firm that could be used for other purposes.What is the opportunity cost of free lunch? ›
A free lunch refers to a situation where there is no cost incurred by the individual receiving the goods or services being provided, but economists point out that even if something were truly free there is an opportunity cost in what is not taken.What is the opportunity cost of going out to dinner? ›
Answer: If the next-best alternative to eating out is eating at home, then the opportunity cost of eating out is the money spent. In addition, another opportunity cost is the experience you forgo by not eating a home-cooked meal. In other words, the opportunity cost is the value of the next best use of your resources.What is an example of opportunity cost for a restaurant? ›
Explicit opportunity cost has a direct monetary value. For instance, if a restaurant buys $1,000 worth of ground beef, the cost is the other things that it could have purchased with that money, like chicken wings or hamburger buns. Implicit opportunity cost, on the other hand, does not have a direct monetary value.What is a simple explanation of opportunity cost? ›
What Is Opportunity Cost? Opportunity costs represent the potential benefits that an individual, investor, or business misses out on when choosing one alternative over another.How do you explain opportunity cost to students? ›
Elementary / Middle School:
Tell them that the one they didn't pick is called “The Opportunity Cost.” Have them say it out loud! In other words, Opportunity Cost is the choice not taken. It's what you “give up” to choose the other option.
the money or other benefits lost when pursuing a particular course of action instead of a mutually-exclusive alternative: The company cannot afford the opportunity cost attached to policy decisions made by the current CEO.What is the basic idea of opportunity cost? ›
The idea behind opportunity cost is that the cost of one item is the lost opportunity to do or consume something else; in short, opportunity cost is the value of the next best alternative.