Opportunity Cost in Personal and Business Finance
Opportunity cost is the cost of a resource or alternative that is forgone by choosing another resource. In other words, it is the next best alternative or the cost of a missed opportunity.
Business Finance
In business finance, this term refers to the profits or potential returns on real estate, equipment and machinery, capital, and other investments. It is the profit from fixed assets and capital if they were to be used differently. And it can be defined in terms of finite resources such as plants, production capabilities, mechanical output, time, and others.Opportunity costs are not reflected on the balance sheet, which includes assets and liabilities such as buildings and equipment, inventories, accounts receivable, short-term investments, taxes and interest payable, and more. While it is not recorded, it is something that managers take into account. This is the case when business owners or top executives make important decisions and must choose between two alternatives. For instance, a construction company may be bidding on several projects and, each of which taking a portion of their resources. They may have to forgo other projects or opportunities that offer better returns or are less time or resource consuming. In this way, opportunity costs may increase the cost of offering products or services. In the view of some experts, they should be reflected as a percentage of the overhead expenses.
How It Works
An investor buys stocks or bonds for $15,000. In 6 months, they have increased in value to $17,500. The return on the investment is 16.6 percent in this case. The investor is looking for other ways to make money and finds government bonds with an annual yield of 7 percent. Investing in shares with a return of 16.6 percent is a better alternative. However, the investor is a choice between different companies. Their shares may appreciate in value by 18 or 20 percent. This is an example of a missed opportunity. A company that owns a building may use it in different ways – as a production facility or office space or it can be rented out. These are alternatives and each has benefits and downsides. For example, the company may relocate to an area with high foot traffic and offer the building for rent.
Implicit and Explicit Costs
Implicit costs are associated with assets and equipment that the business owns and can be used in different ways. For example, trucks can be used for business operations or as delivery vehicles. There are also explicit costs that are associated with direct payments. These are expenses for means of production such as machinery and equipment (e.g. tractors, bulldozers, assembly lines) that are not owned by the company and need to be purchased. If a business spends $15,000 on equipment, the opportunity cost is $15,000.
Personal Finance
Financial returns are only one factor when it comes to making a career choice. If you love to cook, look after children, or paint, it doesn’t make sense to become a lawyer, doctor, or dentist only for financial reasons. A high salary doesn’t mean a better life. Other factors such as satisfaction on the job place and self-actualization also play a role. The choice of career is one example. You may choose to watch TV or read a book at home. But what if you go to the movies, bar, or restaurant and meet the love of your life? All choices that we make in life have consequences. The term is not limited to business or personal finance but covers foregone opportunities such as lost pleasure, time, and others.
Technologies and Resources
Businesses use non-renewable and renewable resources for their operations. Unused solar, thermal, and wind energy, which are infinite sources, are considered a viable alternative to fossil fuels. The development of innovative technologies that utilize alternative sources contributes to sustainable living. The delay in development and implementation is considered an opportunity cost. This is lost potential which leads to a considerable waste of resources. The main idea behind this concept is the effective and cost efficient use of scarce and valuable resources, including physical resources, time, and others. Individuals and businesses choose between mutually exclusive alternatives.
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