Financial Management

What are Opportunity Costs? – With Example

Opportunity Costs

When choosing between two alternative options, typically, only one option can be chosen. When this occurs, you may incur opportunity costs for choosing one option over another.

For instance, if you are deciding between entering the workforce immediately after obtaining your undergraduate degree or continuing your education at the graduate level, you will incur an opportunity cost. If you want to begin working immediately, the opportunity cost includes foregoing a graduate degree and any career restrictions or advancements that may follow from this decision.

If you opt to go graduate school right after high school, your opportunity cost is the income you could have earned by entering the workforce soon after graduation.

In business, opportunity cost is often used to make decisions about what projects to pursue and which products to produce. For example, if a company has two potential projects with equal expected returns, it will choose the project with the lower opportunity cost.

Opportunity Costs – Example

Carolina Clusters, Inc., a candy manufacturer in a resort town, just bought a new taffy pulling machine for $27,000 and is planning to increase the production of salt-water taffy. Due to the increased production, Carolina is deciding between hiring two part-time college students or one full-time employee. Each college student would work half days totaling 20 hours per week, and would earn $12 per hour.

The full-time employee would work full days 40 hours per week and would earn $12 per hour plus the equivalent of $2 per hour in benefits. Each employee is given two t-shirts to wear as their uniform. The t-shirts cost Carolina $8 each. In addition, Carolina provides disposable hair coverings and gloves for the employees. Each employee uses, on average, six sets of gloves per eight-hour shift or four sets per four-hour shift. One hair covering per shift per person is typical. The cost of the hair covering is $0.05 per covering and the cost of a pair of gloves is $0.02 per pair.

Identify any relevant costs, relevant revenues, sunk costs, and opportunity costs that Carolina Clusters needs to consider in making the decision whether to hire two part-time employees or one full-time employee.

Solution

Relevant costs:

  • $2 per hour for benefits
  • $16 for two t-shirts: Hiring one full-time person will result in a $16 expenditure for t-shirts. Hiring two college students would result in $32 in t-shirt expenditures. Thus, the relevant t-shirt cost is the $16 difference.
  • $0.05 for a hair covering: Hiring one full-time person will result in $0.05 per day in hair covering costs but hiring two college students would result in $0.10 per day in hair covering costs; thus, the relevant hair covering cost is the $0.05 difference.
  • $0.04 for a pair of gloves: Hiring one full-time person will result in $0.12 (6 × $0.02) per day in glove costs, but hiring two college students would result in $0.16 (8 × $0.02) per day in glove costs. Thus, the relevant glove cost is the $0.04 difference.

Relevant revenues: None

Sunk costs: $27,000 for the taffy machine

Opportunity costs: None

Conclusion

In economics and business decision-making, opportunity cost is the value of a choice made when another mutually exclusive choice must be given up. It is the cost of the next best opportunity foregone. In other words, opportunity cost is what you give up when you make a choice.

Opportunity cost is an important concept in management accounting because it allows businesses to make more informed decisions. By understanding the opportunity cost of each option, businesses can choose the option that maximizes value.

When considering a decision, businesses must weigh the opportunity cost of all the potential options. The opportunity cost of each option is the value of the next best alternative. To make a decision that maximizes value, businesses must choose the option with the lowest opportunity cost.

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