Opportunity Costs

An opportunity cost is a benefit, profit, or value of something that must be foregone to acquire or achieve another outcome/product/service. Since every resource (land, money, time, etc.) can be put to alternative uses, every action, choice, or decision has an associated opportunity cost.

Sometimes a proposed investment project may use the existing resources of the firm for which explicit, or adequate, cash outlays may not exist. The opportunity costs of such projects should be considered. Opportunity costs are the expected benefits, which the company would have derived from those resources if they were not committed to the proposed project. Assume, for example, that a company is considering a project, which requires 7,000 cubic feet of area. Also suppose that the firm has 10,000 cubic feet of area available. What is the cost of the area available within the firm if it is used by the project? One answer could be that since no cash outlay is involved, therefore, no charges should be made to the project. But from the point of the alternative investment opportunity foregone by transfer-ring this available area to the project, it seems desirable to charge the opportunity cost of the area to the project Suppose that the company could rent the area at Rs 18 per cubic feet, then Rs 1,26,000 should be considered as the opportunity cost of using the area. The opportunity cost of other resources can also be computed in the same manner. It may be sometimes difficult to estimate opportunity cost. If the resources can be sold, its opportunity cost is equal to the market price. It is important to note that the alternative use rule is a corollary of the incremental cash flow rule.