- Identify opportunity costs
What is an opportunity cost?
You have a part-time job while you are attending school. It is spring break and you would love to take a week off and lay on the beach and not do anything! However, if you take the week off, you won’t get a paycheck. So what is the cost of taking that week off?
The loss of wages for that week is called an opportunity cost. It is the cost of what is lost if one decision is made over another. These costs won’t show up anywhere in your accounting records, but as a manager, you need to be very aware of the missed opportunities for decisions you make!
Take a look at this example:
Investopedia defines opportunity cost as follows:
Opportunity cost refers to a benefit that a person could have received, but gave up, to take another course of action. Stated differently, an opportunity cost represents an alternative given up when a decision is made.
Although that definition relates to opportunity costs in investing, in the business operations, it has a similar meaning. We can talk about opportunity costs when we think about making a component needed for our product as opposed to buying it from a supplier already made. Let’s look at an example:
Hupana currently buys the soles that go on their awesome running shoes from a supplier premade and ready to attach to their shoes. The supplier is charging $5.00 per sole. Hupana wants to look at the option of making the soles in house, because they have some empty space in their building, that would be a perfect fit for the equipment needed to make the soles. Just to make this simple, let’s assume Hupana already owns the equipment to make the soles.
We know that Hupana makes 2,000 pairs of shoes per year. So they pay their supplier $10,000 for the premade soles.
Let’s take a look.
|Difference in favor of MAKING||$400|
|Hupana Make or Buy Decision|
|Relevant Costs: Make||Relevant Costs: Buy|
|Direct Materials ($2.50 per sole × 2000 soles)||$5,000.00|
|Direct Labor (.1hr/sole at $20/hour)||$4,000.00|
|Variable Overhead (.1hr/sole at $3/hour x 2000 soles)||$600.00|
|Depreciation of equipment (not relevant)|
|Allocation of fixed overhead (not relevant)|
|Cost of buying||$10,000.00|
So if the space we would use to make the soles is sitting idle right now, then, this analysis would suggest we should start to make the soles in house, right?
But what if the space used to make the soles, could also be used to expand to add another line of shoes? And what if, that additional line of shoes would add $5000 to the net income of the company?
|Difference in FAVOR of continuing to buy from the supplier||$4,600|
|Total annual cost||$9,600.00||$10,000.00|
|Opportunity Cost-Additional Shoe Line||$5,000.00|
So did that change the plan? Yes—Hupana would be better off adding a shoe line, and continuing to purchase their soles from their supplier!
This opportunity cost would be lost if they decided to make the soles in-house. Remember, they already own the equipment to make them, but that is a sunk cost, as there is no way to recoup that cost anyway.