OPPORTUNITY COST

by Dipti Biswas  (2910008)

INTRODUCTION

The cost of passing up the next best choice when making a decision. For example, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose the asset could have been used for. Opportunity cost analysis is an important part of a company's decision-making processes, but is not treated as an actual cost in any financial statement.

Definition of 'Opportunity Cost'

1. The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.

2. The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment - say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% - 2%).

Investopedia explains 'Opportunity Cost'

1. The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages.

Here's another example: if a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.).

In both cases, a choice between two options must be made. It would be an easy decision if you knew the end outcome; however, the risk that you could achieve greater "benefits" (be they monetary or otherwise) with another option is the opportunity cost.

Historical background

The concepts of incremental cost, opportunity cost, sunk cost, and cost allocation are identified and discussed in the context of early U.S. foreign policy. The case is derived from an authentic exchange of views between Thomas Jefferson and John Adams about how the United States should protect its merchant shipping against the Barbary pirates. Both men compare the cost of waging war against the Barbary States with the cost of paying ransom for captured U.S. seamen and bribes to protect future shipping. Adams quantifies the opportunity cost associated with not taking any action. Jefferson articulates an incremental costing argument, on the assumption that the U.S. should build a navy regardless of U.S. policy toward the Barbary States. The case constitutes a brief introduction to management accounting by illustrating various cost concepts. The case lends itself to a discussion of how cost information can be chosen to support a particular course of action, and it can also prompt a discussion of the historical origins of management accounting.

It is impossible to understand Pakistan without addressing its relationship with India.  The two nations began their history as part of the same entity – British colonial India. Modern Pakistan and India emerged as independent states within one day of each other in 1947, and their identities and histories have been intertwined, and often at odds, ever since.  Pakistan’s relationship with India has over the years contained enormous tangible and opportunity costs for the Muslim nation.  Tangible costs have come in the form of money, lives, and international goodwill lost, while opportunity costs have included resources and energy that could have been spent elsewhere and in other ways.  Consequently, what would appear on the surface to be a foreign relations issue has intimately shaped the development of Pakistan’s own domestic institutions and dynamics.

MECHANISM

An opportunity cost example

Since learning about opportunity costs is best illustrated with numbers, we present an example. Let’s compare a hectare of forest to a hectare of agricultural land.  Figure 1.2summarizes the carbon stock and profits of each land use. The forest has approximately 250 tons of carbon per ha (tC/ha), whereas agricultural use has about 5 tC/ha.14

The estimated profits from agriculture are $400/ha, while forest profits are $50/ha, expressed in Net Present Value (NPV) terms.15 .While the forest stores more  carbon, agriculture produces more profit, revealing a land use tradeoff between carbon and profits. Converting a forest into an agricultural land use increases profits by $350/ha but reduces carbon stock by 245 tC/ha. 

The opportunity cost of not changing forest to agriculture is equal to the $350/ha of profit difference ($400–$50=$350/ha)  divided by the  245 tC/ha not emitted (250–5=245tC/ha). Thus, the opportunity cost, per ton of carbon, is $1.43/tC (=$350/245tC). REDD+ compensation, however, is not based on carbon (tC), but rather on emissions of carbon dioxide equivalents (CO2e). A conversion factor of 3.67 is needed to translate tC .These figure are illustrative. Significant variation can arise within landscapes and across countries.

Net present value is the summing of a stream of annual profits, whereby future profits are reduced by a factor (i.e., discount rate) that reflects the inherent preference for money now, rather than profits generated in the future.

So, the potential emissions of the land use change is 899tCO2e/ha (245tC/ha * 3.67 tCO2e/tC = 899tCO2e/ha).

With an estimate of the difference in profits ($350/ha) and the emissions avoided (899 tCO2e/ha), an opportunity cost of  avoided  emissions can be estimated.  The opportunity cost is $0.39/tCO2e of not converting a forest into agricultural land.

This per ton carbon equivalent estimate is one way of expressing opportunity costs. Yet for landholders, the more relevant way to express opportunity costs is per hectare. In this example, the per unit land area estimated opportunity cost is $350/ha.  In other words, by not converting a forest to agriculture, the farmer forgoes $350/ha in NPV profits.

Although estimating  opportunity costs is relatively simple in theory, in practice, generating reliable estimates can be difficult. Multiple series of calculations are required, each with possibilities of making errors. In addition, numerous assumptions about measures and methods need to be  made, often requiring discussion and agreement, in order to generate precise and accurate estimates of both carbon and profits of land uses.

It is important to note that opportunity costs are not based on land use, but rather the change in land use. Land use change is the difference between an initial state and an end state. The time period of analysis can be of any length, but should follow the Intergovernmental Panel on Climate Change (IPCC) reporting requirements (i.e., 5 years) and/or the time frame of a national strategic plan (perhaps more than 5 years

Current Relevance

We use a database of recent high-technology IPOs to estimate opportunity cost of capital for venture capital investors and entrepreneurs.  Entrepreneurs face the risk-return tradeoff of the CAPM as the opportunity cost of holding a portfolio that necessarily is underdiversified.  We model the entrepreneur’s opportunity cost by assuming the venture financial claim and a market index comprise the entrepreneur’s portfolio.  We  estimate total risk and correlation with the market and examine how these estimates and opportunity cost of capital vary with underdiversification and by industry and financial maturity ofearly-stage firms.  Early-stage firms have market risk levels similar to more established firms in our sample, but have higher total risk.  Equity of newly public, high tech firms generally is more than five times as risky as the market and correlations with the market generally are below 0.2 so that beta is close to one.  Assuming reasonable levels ofunderdiversification in the entrepreneur’s portfolio and a one-year holding period,depending on industry and stage of development, the entrepreneur’s opportunity costgenerally is two to four times as high as that of a well-diversified investor.  With a 4.0 percent risk-free rate and 6.0 percent market risk premium, for the sample average observation, the cost of capital of a well-diversified investor is estimated to be 11.4 percent, or 16.7 percent before the management fees and carried interest of a typical venture capital fund.  The corresponding cost of capital for an entrepreneur with 25 percent of total wealth invested in the venture is estimated to be 40.0 percent.  Empirical results are of the same order of magnitude as estimates derived by others, using different methods, but have the advantage of being based on public data.

 

Conclusion

Opportunity costs are all around us and they differ from individual to individual. Take one look at Steve Jobs and Bill Gates and think of the opportunity costs if they had decided to forgo their entrepreneurial pursuits and continue their college education instead. Had they not been blessed with business acumen, things would be very different now. Ultimately, opportunity costs apply to anything which is of value to a person and being conscious of how they apply to your situation can help in making a satisfactory choice/decision by considering the value or benefit of the next best alternative.

Important conclusion on the role of opportunity cost in financial decision making.As what I understand from the reading, opportunities cost could be the price that going to pay in the future, in another words, we have to make decision among the alternatives. Although it would be enormous to possess all worthy things, but resources are limited, which allow serving one purpose at one time. Market demand is the key factor to help the management to decide which is the best product or service to implement. In addition, the value of choice should have further benefits and cost relatively. For example, play station games and women magazines are two the most demanding productions; due to the economy crisis, company need to decide cutting back one production (though this is the next best value). As Livingstone (2007) wrote that "Effective management decisions require careful comparison of costs and benefits of alternative action". As a result, play station game shows growth potential and less cost compare to magazines. This could be the better production outcome and reduce unnecessary use of resources.