Opportunity cost definition
Broadly speaking, the definition is the profit or benefit lost when one alternative is selected over another. Let’s say you have $100,000 and choose to invest it in machinery that will generate a return of 4 per cent per annum. If you could have chosen another investment that would have generated a return of 6 per cent, then the 2 per cent difference between the two options is the opportunity cost of your decision. When economists use this term when referring to a resource, they are referring to the next-highest valued alternative use of that resource.
How to calculate opportunity cost
You can estimate the amount of money foregone by using the opportunity cost formula, which is:
FO − CO
Where:
FO is the return of the best foregone option
CO is the return of the chosen option.
Types of opportunity cost
Opportunity cost does not always involve tangible costs. In its implicit form it cannot be easily accounted for because all options don’t involve money. For example, if you own a business and take a day off to volunteer in the community, the implicit cost would be the money not earned by spending the day volunteering, but you cannot put a dollar value on the benefits of volunteering, both for you and the cause you are supporting.
Here’s another example. Let’s say you earn $50 per hour and you drive 30 minutes longer in total than the closer alternative to save $15 an item at a shop. Even though you don’t work 24 hours a day, your time has potential value. So by taking the longer trip to purchase the item, you have actually lost $10 when you consider the opportunity cost ($15 savings – $25 for the extra time spent = –$10).
Explicit costs are costs that can be easily counted. For example, if you spend $10,000 on new computers for your business, the explicit cost is what your business could have alternatively done with that money, such as paying for additional advertising.
The opportunity costs of accounts receivable
Accounts receivable is one area where the concept of opportunity cost can be applied in decision making. Businesses that sell to other businesses often offer invoice payment terms for many good reasons. In a survey commissioned by Moula, SME owners said they offer invoice payment terms because:
- It enables them to sell more – 21 per cent of SME owners
- Their competitors do – 30 per cent
- It’s an important selling point – 34 per cent
- Their customers expect it – 47 per cent.
Although there are many good reasons for offering invoice payment terms, it comes with a cost. The same survey revealed that 63 per cent of SMEs experience cash flow shortages as a result of late payments and 47 per of SMEs hold back from investing in their business because they don’t have the cash flow available to do so. This clearly shows that there is such a thing as payment term opportunity cost.
Research presented in Healthcare Financial Management Magazine estimated the average opportunity cost of accounts receivable. These costs are 2.50 per cent of the amount outstanding at 60 days, 7.50 per cent at 90 days and 12.50 at 120 days. Given these figures, let’s consider a hypothetical opportunity cost example. If a business has $30,000 outstanding at 60 days, $20,000 at 90 days and $10,000 at 120 days, the value of opportunity cost is:
($30,000 ✖ 0.0250) + ($20,000 ✖ 0.0750) + ($10,000 ✖ 0.1250) = $3,500
Remember that this amount doesn’t appear on financial statements, such as the Profit and Loss Statement. It’s simply the profit forgone as a result of not having the money to invest in growing your business. So if this business earns 10 per cent profit on its revenue, it has missed out on $35,000 revenue for the month as a result of having money tied up in receivables.
Opportunity cost is only one element of the carrying costs of accounts receivable. In addition to the time spent on managing accounts receivable, there are administrative, finance and bad debt costs.
