Opportunity Costs

What are Opportunity Costs?

Opportunity costs (waiver costs): net benefit, actual benefit & opportunity

The opportunity costs are alternative costs that show lost income or benefits in comparison to another alternative course of action. They are also referred to as the cost of a missed or missed opportunity and a waiver cost.

In this lesson we explain how opportunity costs are calculated, the differences between business and economic perspectives and why opportunity costs are an important factor in decision-making. After this lesson, there are a few more exercise questions to help you practice and deepen what you have learned.

Why is opportunity cost so important in decision making?

If several alternative courses of action are opposed to each other, each individual must be assessed in order to be able to make a decision for one or against the remaining ones.

According to whicheverhealth.com, opportunity costs are used in both economics and business administration.

  • Opportunity costs in economics:
    In economics, they are used to calculate the lost benefit. They are also used to calculate comparative cost advantages.
  • Opportunity costs in business administration:
    In business administration, they serve as an instrument for making decisions about additional orders and for optimizing production programs.

Opportunity Costs in Microeconomics

In microeconomics, opportunity costs are those costs that arise when opportunities are missed or alternative courses of action are not taken. The resulting reduction in utility means that household or company resources are not used optimally. That is why opportunity costs are often referred to as alternative costs in this context, as funds can only be used for a specific purpose.

If the funds are instead invested in an alternative, corresponding alternative costs arise due to the loss of benefit. In this respect, opportunity costs cannot be avoided, as the decision must always be made in favor of one of several alternatives.

Opportunity Costs

Example of opportunity costs in microeconomics

An elderly couple has bought a condominium in the center of Hamburg and plans to live in it from now on. They are satisfied with this decision, as they will no longer pay rent in the future and will only pay for the running costs such as B. electricity, hot water and heating must come up.

However, the couple’s son does not see this decision as the best possible alternative course of action. Rather, he is of the opinion that the apartment should be rented out due to its central location. Although the couple does not have to pay rent themselves, they also miss out on rental income of € 1,500 per month, which they could benefit from if they moved into a cheaper apartment outside of Hamburg for € 700 per month.

In the case of the first alternative course of action, the opportunity costs thus amounted to € 800.

Opportunity Costs in Business

From a business perspective, opportunity costs refer to lost profit margins from unselected alternative courses of action. In this respect, opportunity costs are not actually costs. Rather, they are hypothetical costs, as they are not taken into account in business cost and performance accounting.

However, this does not detract from their importance in the decision-making process. When making decisions about future production programs and additional orders, the opportunity costs are often brought into focus.

Input and output related opportunity costs

In addition, a distinction is made between input and output-related opportunity costs in the field of business administration.

  • In the case of input-related opportunity costs, the relative contribution margin is decisive, i.e. the contribution margin that relates to the corresponding production factor, which can be, for example, raw materials, labor or energy consumption.
  • The output-related opportunity costs are calculated from lost profit margins of unselected alternative courses of action. They result from the output of the production process, with another distinction being made between alternative costs and optimal costs.

In the case of alternative costs, a comparison is made between the selected option and the next best alternative; in the case of optimal costs, a comparison is made with the optimal use of the funds used.

Example of opportunity costs in business

An entrepreneur is faced with the decision to invest € 50,000 either in expanding his business or in securities.

For this purpose, he calculates the expected profit. Using the internal rate of return, he determines the rate of return that he could generate within a year if he invested the money in his company.

With an internal rate of return of 5%, the return would be € 2,500. An investment in securities would result in an interest rate of 6%, which corresponds to € 3,000. Nevertheless, he decides to invest in new production equipment in order to be better equipped for future orders.

As a result, he misses a profit of € 500 (€ 3,000-2,500) in the following year, which represents the opportunity costs (lost interest income).