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Finance From A to Z: Week 15 (O)

Finance From A to Z: Week 15 (O)

O is for Opportunity Cost

If you want to successfully run a business, the financial variables that impact its profits must be closely monitored; specifically, this involves recognizing the existence of the accounting and economic costs of doing business. However, despite the fact that the two phrases seem similar, it is important to not misconstrue them for one another given that accounting and economic costs actually have significant differences. Accounting costs only take into consideration the explicit costs associated with a decision, whilst economic costs also take into consideration the implicit costs of that decision, too. In the financial world, these explicit and implicit costs are both types of opportunity cost. Hence, this week’s submission will explore exactly what opportunity cost entails!

What is Opportunity Cost?

Opportunity costs represent the potential benefits that an individual, investor, or business misses out on when choosing one alternative over another. In other words, opportunity cost refers to what you have to give up to buy something else (usually the value of the next-best alternative when a decision is made). Opportunity costs, however, are, by nature, supposed to be undetected, and therefore are easily overlooked or excluded when making any decision. With that said, when the value of an opportunity cost of a decision is carefully considered, not only will businesses be more likely to realize higher profits from their decision making, but also be more aware of their resources, assets and the business itself. 

 

 Opportunity cost can be understood as the sum of  two parts: explicit costs and implicit costs. The first of these, explicit costs, are the direct costs of an action (business operating costs or expenses), executed either through a cash transaction or a physical transfer of resources. In other words, explicit opportunity costs are the out-of-pocket costs of a firm that are easily identifiable. For example, the explicit cost of purchasing a candy bar, for example, would solely depend on the pricing of that good. If the bar were priced at $4, then the explicit cost of purchasing the candy bar would be $4. Implicit costs, however, require a bit more explanation given that these costs are often hidden to the naked eye. 

With respect to opportunity cost, implicit costs are the opportunity costs of utilizing resources owned by the firm that could be used for other purposes. The key characteristic of an implicit cost requires that a business uses internal resources toward a project without any explicit compensation for the utilization of resources. For example, implicit costs concerning production include the resources utilized to facilitate the production, such as factories and human labour.

Finally, to use an example that combines the two, consider a worker, Ted. Ted happens to leave work an hour and spends $50 on a meal. That being said, Ted also gets paid an hourly wage of $15. In this case, the explicit cost of this situation equates to the total cost of the meal, whilst the implicit cost equates to the $15 that Ted could have made instead. The total opportunity cost in this case would thereby be $65.

Think about how you can apply this newfound knowledge of opportunity cost into your own decision making! That’s all for this week, thank you for reading!



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