Opportunity cost

Opportunity cost is the sacrifice made when selecting one product or service over another.

The popular political slogan ‘Guns or butter?’ suggests that national defence is the price to be paid for not fulfilling high consumer expectations, and vice versa.

Also see: cost benefit analysis

Source:
J M Buchanan, Cost and Choice (Chicago, 1969)

Types of opportunity costs

Explicit costs

Explicit costs are the direct cost of an action, executed either through a cash transaction or a physical transfer of resources.^[4] In other words, explicit opportunity costs are the out-of-pocket costs of a firm.^[8] With this said, these particular costs can easily be identified under the expenses of a firm’s income statement to represent all the cash outflows of a firm.^[9]

Examples are as follows:^[8][10]

• Land and infrastructure costs
• Operation and maintenance costs – wages, rent, overhead, materials

Scenarios are as follows:^[9]

• If a person leaves work for an hour and spends $200 on office supplies, then the explicit costs for the individual equates to the total expenses for the office supplies of $200.
• If a printer of a company malfunctions, then the explicit costs for the company equates to the total amount to be paid to the repair technician.

Implicit costs

Implicit costs (also referred to as Implied, Imputed or Notional costs) are the opportunity costs of utilising resources owned by the firm that could be used for other purposes. These costs are often hidden to the naked eye and aren’t made known.^[10] Unlike explicit costs, implicit opportunity costs are normally corresponding to intangibles. Hence, they cannot be clearly identified, defined or reported.^[9] In terms of factors of production, implicit opportunity costs allow for depreciation of goods, materials and equipment that ensure the operations of a company.^[11]

Examples of implicit costs regarding production are mainly resources contributed by a business owner which includes:^[8][11]

• Human labour
• Infrastructure
• Time

Scenarios are as follows:^[9]

• If a person leaves work for an hour to spend $200 on office supplies, and has an hourly rate of $25, then the implicit costs for the individual equates to the $25 that he/she could have earned instead.
• If a printer of a company malfunctions, the implicit cost equates to the total lost production time due to the machine breaking down.

Excluded from opportunity cost

Sunk costs

Sunk costs (also referred to as historical costs) are costs that have been previously sustained and cannot be recovered. Since sunk costs are costs that have been incurred, they remain unchanged by both present and future action.^[12] Decision makers who recognise the insignificance of sunk costs then understand that the “consequences of choices cannot influence choice itself”.^[2]

A scenario is given below:^[13]

A company used $5,000 for marketing and advertising on its music streaming service to increase exposure to target market and potential consumers. In the end, the campaign proved unsuccessful. The sunk cost for the company equates to the $5,000 that was spent on the market and advertising means. This expense is to be ignored by the company in its future decisions, and highlights that no additional investment should be made