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Opportunity Cost
Everything has a cost. That statement may sound simple or it may sound confusing; but the truth of the statement cannot be denied, nor should it be ignored.
Frequently, we think of cost as "the amount of money I have to pay to acquire something." But there are other categories of cost that need to be considered in making decisions. This page describes opportunity cost; that is, "what do I give up or forsake when I decide to pursue an activity."
For example, if I decide to use my cash to purchase a car, I no longer can deposit that money in a savings account wherein I would have earned interest. Part of my opportunity cost of buying the car is not being able to earn interest on the cash used to make the purchase.
Opportunity cost can also be described in terms other than cash; for example, "I give up the opportunity to study when I decide to visit with my friends," or "I give up my opportunity to earn a wage when I spend my time studying," or "I give up an opportunity to buy equipment if I purchase land." Another example could be society giving up the opportunity to enjoy the benefits of a free flowing river when it decides to construct a dam. Society also gives up (or delays) the opportunity to build a road or school when it decides to build the dam. Accordingly, everything has a cost -- an opportunity cost.
Accountants do not consider opportunity cost in calculating whether your business earned a profit or incurred a loss; but decision makers have to think about what opportunity they will not be able to pursue because they decide on an alternative action.
When considering opportunity cost, it may be helpful to consider the economic resources the business owner likely has invested in the business. As discussed on other pages, these include land, labor, capital, information and risk. The owner wants (needs) a return on these resources to justify having them investing in the business, otherwise, the owner will likely disinvest from this current business and reinvest the resources in an alternative business or opportunity.
Last Updated November 6, 2010
Email: David.Saxowsky@ndsu.edu
This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.
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