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Would you please help me understand opportunity cost?

Author:
Harold Averkamp, CPA, MBA

You might think of opportunity cost as the profit you had to forego.

Let’s illustrate this with a little story. Suppose that you are the sole owner of a company which uses a special machine to produce a very unique product. Your company has a huge backlog of orders for the product. Every hour that the machine is running, your company is able to generate sales of $500 while incurring incremental costs and expenses of $200. As a result, your company’s profit is increasing by $300 for each hour that the machine is running.

Now suppose an employee failed to perform a routine maintenance task which causes the machine to be shut down for 10 hours. The repair bill to get the machine running was $400. What was the cost of the machine being down for 10 hours? The accounting records will report $400 in the account Repairs and Maintenance Expense. But as the owner, you are likely to be more upset that the employee cost you $3,000 (10 hours X $300) in lost profits and upset customers.

In the above story the opportunity cost was $3,000 of lost profit + the cost of the upset customers. (From the owner’s perspective, the total cost was the $400 repair bill + $3,000 of opportunity cost described above + the opportunity cost consisting of future lost profits from lost customers.)

Now let’s modify the story. Suppose the machine that was idled by employee negligence was not a special machine and there was no backlog of orders for the product. The repair bill was the same $400. In this situation you will not be foregoing any sales or losing any customers. Therefore the profit foregone is $0. In other words, there is no opportunity cost of the machine being down for 10 hours. All you have is the $400 repair bill.

This concept of opportunity cost is relevant in making decisions. For example, in deciding whether to make or to buy a component, the opportunity cost is an important consideration: If your plant has idle capacity, you might opt to make a component because there is no opportunity cost—no profit being foregone as you spend time making the component. On the other hand, if your plant is operating at full capacity, you would have to forego the profit on some items presently being produced (an opportunity cost) in order to make the components.

The concept of opportunity cost is also relevant when setting transfer prices between divisions or subsidiaries of a large company.

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About the Author

Harold Averkamp

For the past 52 years, Harold Averkamp (CPA, MBA) has
worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com.

Learn More About Harold

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