What is Opportunity Cost?

 

This concept is applicable only when an organisation has limited resources. Use of  these limited resources (key factory) for one alternative, deprives you from using it for another alternative.  This opportunity lost is commonly known as opportunity cost.

 

Example 1 :

Mr. A wanted to become a Chartered Accountant.  But he also loves cricket and wants to play for Indian cricket team. However, both the options demand lot of time and efforts.

Mr. A chose to do CA and hence he left the cricket coaching.  The opportunity cost of doing CA is to leave Cricket.

However, if a student could pursue both the career options i.e. CA and also Cricket in the same time, then there is no opportunity cost.

 

Example 2 :

Our company at present has a capacity to produce only 10,000 units in a year.  However, market can accept any number of units which we can produce.  We sell our product in the market @  Rs. 100 per unit.  The variable cost of our product is Rs. 60 per unit.  Hence, contribution is Rs. 40 per unit.  Our total fixed cost is Rs. 1,00,000 p.a.

While producing these 10,000 units, we also produced 500 defective units, which are scrapped and could not be sold to the customers.  In this situation, we could sale only 9,500 good units to our customer.

In this situation, the opportunity cost of these 500 defective units shall be the loss of contribution from these units i.e. 500 units x Rs. 40 per unit = Rs. 20,000

Total loss to our organisation is :

            = Variable cost of production + Opportunity cost

            = ( 500 units x Rs. 60 ) + ( 500 units x Rs. 40 )

            = 30,000 + 20,000 = Rs. 50,000

Note : Fixed cost of Rs. 1,00,000 p.a. is to be ignored in this calculation, because whether we produce & sale 9,500 units or 10,000 units, this cost is going to be incurred.  Hence, it is irrelevant.

 

 

 

 

Example 3 :

Our company at present has a capacity to produce only 10,000 units in a year.  However, market can accept only 6,000 units.  We sell our product in the market @  Rs. 100 per unit.  The variable cost of our product is Rs. 60 per unit.  Hence, contribution is Rs. 40 per unit.  Our total fixed cost is Rs. 1,00,000 p.a.

We produced total 6,500 units, out of which, 500 units were defective and hence scrapped. We sold 6,000 good units to our customer.

In this situation, the opportunity cost of these 500 defective units is NIL.

Because, in this example, key factor is not production but it is sales demand.  We have satisfied the entire market demand of 6,000 units and we lost no opportunity to sale.  Hence, there is no opportunity cost in this situation.  In example 2, the market demand was unlimited and in the current situation, it is limited, hence there is a difference.

However, loss to our organisation due to defective production is :

            = Variable cost of production

            = ( 500 units x Rs. 60 ) = Rs. 30,000

Note : Fixed cost of Rs. 1,00,000 p.a. is to be ignored in this calculation, because whether we produce & sale 9,500 units or 10,000 units, this cost is going to be incurred.  Hence, it is irrelevant.