Definition of Opportunity Costs
Opportunity costs are the profits a company (or person) missed, or the contribution margin that was missed. Opportunity cost might be thought of as the opportunity lost or the opportunity missed.
The missed contribution margin is the net of the revenues that were missed minus the variable costs that were avoided.
Calculating Opportunity Costs
Since opportunity costs are the missed revenues associated with a missed opportunity you won’t find them in the company’s general ledger. You will have to estimate them. The same holds true for the variable costs and expenses associated with the missed revenues and the missed opportunity.
Example of Calculating Opportunity Costs
Assume that a small manufacturer has a limited number of machine hours available on its large specialized machine. The setup time to prepare the machine to run a different job is 4 hours. During these 4 hours, the company is losing the opportunity to generate profits had the machine been running.
Next, assume that the machine is billed out to customers at $200 per hour and the variable costs of operating the machine are estimated to be $60 per hour. This means that when the machine is not running, the company is missing the opportunity to earn a contribution of $140 per machine hour. During the 4-hour setup time, the company is missing/losing/foregoing a contribution of $560 (4 hours X $140). In other words, the company’s opportunity cost for setting up the machine is $560.
A bean counter might look in the company’s payroll records and say that the cost of setting up the machine is 4 hours X $40 (the hourly wage and benefits of the setup person) = $160. An astute business person would say that the real cost of having this machine idle for 4 hours X $140 (the lost hourly contribution margin) = $560.
Even though opportunity cost of $560 per setup is not found in the general ledger accounts, it should be used when quoting or setting prices for using the machine. In other words, the pricing of the machine’s output should begin with $560 for setting up the machine. If the company finds its prices to be higher than its competition, it should find ways to reduce the number of hours necessary to set up the machine and/or find other areas for reducing costs.
