Provided by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
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Opportunity cost is the highest alternative use value of resources used up or committed to a particular use.
Example 1*: A clothing manufacturer holds stocks of various types of cloth. Material A consists of 1,000 yards purchased several years ago at $1 per yard. This type of cloth is no longer fashionable, but it could currently be sold for 50 cents a yard. However, the manufacturer is offered a contract that would use up the stock of Material A and produce revenue of $1,800. The additional resource cost associated with the contract would be $1,000. Should the manufacturer accept the contract?
Using historical cost as a guide the answer would be no because the contract will show an accounting loss of $200. ($1,800 - material cost of $1,000 - other resource cost of $1,000 = $-200). But material A's value in its best alternative use is only $500. Based on the opportunity cost the answer is yes because the contract will show an economic profit of $300. ($1,800 - material cost $500 - other resource cost of $1,000 = $300). However, the company's management might not accept the correct answer because their income statement would show a $200 loss.
Example 2*: Suppose in the example above the contract for Material A would generate revenue of $2,200, and an alternative contract to sell Material B is also available to the clothing manufacturer who has 1,000 yards of Material B that cost $2 per yard. Material B is still fashionable and selling for $2 per yard. The contract for Material B would generate $3,500 in revenue and the additional resource cost would be $1,000, i.e., the same as the contract for Material A. Assuming the manufacturer only has enough capacity to accept one contract, which contract should be chosen?
Using historical cost as a guide the contract for B appears to be more profitable. For Material A the calculation is ($2,200 - material cost of $1,000 - other resource cost of $1,000 = $200). For Material B the calculation is ($3,500 - material cost $2,000 - other resource cost $1,000 = $500). But again, material A's value in its best alternative use is only $500, so the calculation based on opportunity cost is ($2,200 - material cost of $500 - other resource cost $1,000 = $700). If the answer is based on historical cost, the manufacturer would choose the less profitable contract.
Example 3**: A company estimates that it needs 120,000 units of direct material for the following year. The material can be purchased in quantities of 10,000 units per month for $10 per unit, or all at once for $9.80 per unit. Note that the average inventory value would be (10,000x$10)/2= $50,000 for the first alternative, and (120,000x$9.80)/2 = $588,000 for the second alternative. Assume that the difference of $588,000 - $50,000 = $538,000 could be invested in risk-free government bonds at say 6% for $32,280 per year. Which alternative should be chosen? The discount for buying the larger quantity is 120,000x.20 = $24,000. Therefore since the opportunity cost of $32,280 exceeds the quantity discount, the company should purchase 10,000 units per month.
Example 4: Grace Barnes who owns and operates a retail store as a single proprietorship is offered $500,000 for her business. The annual net income from the store is $60,000. How should Grace go about making a decision? She needs to consider the opportunity cost of owning and operating the business. Perhaps Grace could sell the store and receive an estimated $40,000 salary by operating a similar store for someone else. She could also invest the $500,000 she receives from the sale in the stock market, government savings bonds, certificates of deposit, or money market funds. Her potential salary and earnings on her investments represent the opportunity cost of ignoring the offer. If she could earn a salary of $40,000 and a return above 4 percent on her investments ($20,000+), she should sell from a financial standpoint. However, she might place a high value on being self-employed, and that could alter the decision toward staying with the business. Of course placing the $500,000 in a more diversified portfolio of investments would involve less risk, but the main point of the example is that every alternative involves opportunity cost that should be considered.
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Footnotes:
* Examples 1 and 2 were adapted from Solomons, D. 1966. Economic and accounting concepts of cost and value. In Backer, M. ed. 1966. Modern Accounting Theory. Prentice-Hall Inc. Chapter 6: p. 128. (Summary).
** Example 3 is from Horngren, C. T. and G. Foster. 1991. Cost Accounting: A Managerial Emphasis, Seventh Edition. Prentice Hall. p. 377.
Related summaries:
Leininger, W. E. 1977. Opportunity costs: Some definitions and examples. The Accounting Review (January): 248-251. (Summary and JSTOR link).
Martin, J. R. Not dated. Management accounting terminology. Management And Accounting Web. (Management Accounting Terminology).
Oser, J. 1963. The Evolution of Economic Thought. Harcourt, Brace & World, Inc. See Wieser in Chapter 13. (Summary).