Opportunity Costs: Some Definitions and Examples

Author(s): Wayne E. Leininger

Source: The Accounting Review , Jan., 1977, Vol. 52, No. 1 (Jan., 1977), pp. 248-251
Published by: American Accounting Association

Stable URL: https://www.jstor.org/stable/246049

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THE ACCOUNTING REVVIERW
Vol. L11, No. I
January 1977

Opportunity Costs: Some Definitions

and Examples
Wayne E. Leininger

ABSTRACT: The goal of this paper is to develop operational definitions for opportunity
costs in profit and cost situations. The static inventory problem under risk is suggested as a
means of demonstrating these definitions.

HE term "opportunity cost" fre-
amples
quently is employed in accounting
and economics textbooks and litera-
ture in the area of decision making. In
economics, opportunity costs have been
defined as arising from "foregone op-
portunities that have been sacrificed"
where the "sacrifice of doing something
else is called opportunity cost" (Samuel-
son, 1967, p. 443]. A representative defi-
nition of opportunity cost taken from an
accounting text is "the maximum alterna-
tive earning that might have been ob-
tained if a productive good, service, or
capacity had been applied to some alter-
native use" [Horngren, 1972, p. 948].
"The prospective change in cost follow-
ing the adoption of an alternative ma-
chine, process, raw material, specifica-
tion, or operation" is the definition of
opportunity cost found in an accounting
reference book [Kohler, 1975, p. 335].
Although the accounting definitions
are more specific than the definition cited
from economics, there is an inconsistency
in the accounting definitions. The Horn-
gren definition is in terms of earnings,
while the Kohler definition is in terms of
costs. There are specific examples where
opportunity costs are defined in terms of
earnings or costs. Therefore, these defini-
tions are not all inclusive. In the account-
ing literature, McRae [1970], Burch and
Henry [1974] and McRae [1974] are ex-
of attempts to define opportunity
costs.
If opportunity costs are a norm sought
after in decision making, then certainly
students should have some appreciation
of the concept. It has been my experience
that students indeed recognize the term
but are generally unable to apply the con-
cept in a problem situation. This perhaps
is a result of the confusion and lack of
clear definitions in the literature and
textbooks. After experimenting for sev-
eral years to develop meaningful ex-
amples of opportunity costs, it is this
author's conclusion that the static in-
ventory problem under risk best meets
this instructional objective. (See Starr
and Miller [1962] for additional develop-
ment of the problem.) Students readily
can identify with the family of problems
that can be formulated in this manner.
In addition, static inventory problems
under risk present situations where ex-
amples concerning profit maximization,
cost minimization and the related op-
portunity cost formulations of the prob-
lems can be developed. In this type of
inventory problem, it is assumed that
Wayne E. Leininger is Associate Pro-
fessor at Virginia Polytechnic Institute
and State University.

248

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 Leininger
only one order is possible and that the
probability distribution of demand is
known. Construction of profit and cost
matrices permit the reinforcement of the
operational definitions of opportunity
cost. Since each element of the oppor-
tunity cost matrix must be determined
correctly to obtain the solution, repeated
employment of the opportunity cost
definition is required to solve a single
problem.
For example, assume a merchant is
considering ordering a seasonal item that
will sell for $10 a unit. This merchandise
has a unit cost of $6 and must be sold
within the seasonal period or it has no
market value. Christmas trees, Valentine
candy, Easter eggs, Halloween costumes,
high fashion apparel, newspapers and
flowers for special occasions are exam-
ples of this type of merchandise. The
merchant has only one opportunity to
place an order, and the following prob-
abilities are associated with the demand:
Detimanid
(Units) P(D)
5 .1
6 .2
7 .3
8 .3
9 .1
1.00
Demand
\ ~ ~~5
Order Expected
5 $20 $20 $20 $20 $20 $20
6 $14 $24
7 $ 8 $18
8 $ 2 $12
9 ($4) $6
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249
Based on this information, a profit
matrix and the expected profit for each
inventory policy can be determined.
From this analysis, the merchant
should adopt a policy of ordering seven
units with an expected profit of $24.
This policy would be followed as long
as the selling price, cost and probability
of demand remain unchanged.
To solve the problem employing op-
portunity costs, it is first necessary to
suggest an operational definition. This
definition has proved to be acceptable.
Opportunity Cost (Profit Situation) is the
difference between the profit had the
correct policy been adopted and the profit
resulting from the policy employed.
Employing this definition, we can de-
termine the opportunity cost matrix and
the expected opportunity costs. It is
useful to solicit student participation
in developing the opportunity cost
matrix. Significant variation responses
has been found until the definition of
opportunity is conceived properly. Once
again, the merchant should pursue a
policy of ordering seven units to mini-
mize the expected opportunity cost. At
this point, it is of interest to point out the
relationship of the differences between
the expected profits and the expected
opportunity costs. Discussion also can
consider the consistency of the profit
TABLE I
PROFIT MATRIX
6 7 8 9
Profit
$24 $24 $24 $23
$28 $28 $28 $24*
$22 $32 $32 $22
$16 $26 $36 $17
 250 The Accounting Review, January 1977

TABLE 2

OPPORTUNITY COST MATRIX PROFIT SITUATION

Demand
5 6 7 8 9 Expected
0rder Opportunlit is Cost

5 $ 0 $ 4 $8 $12 $16 $8.40

6 $ 6 $ 0 $ 4 $ 8 $12 $5.40

7 $12 $ 6 $ 0 $ 4 $ 8 $4.40*

8 $18 $12 $ 6 $ 0 $ 4 $6.40

9 $24 $18 $12 $ 6 $ 0 $11.40

maximization and opportunity cost mini- Number of

mization decision criteria. Failures P(F)

However, the opportunity cost con- 0 .2

cept also can be employed when there are 1 .4
2 .2
no profit considerations. A static inven- 3 .1
tory problem under risk also can be de- 4 .1

veloped under these circumstances. As-

sume that a merchant is faced with order-
ing sets of spare parts for a refrigeration
system. This merchant can place one
order for the spare parts at a cost of $500
a set. If the equipment should fail and the
spare parts are not available, a $2,000
expenditure must be incurred. Assume
the following probabilities are associated
with number of failures of the system.
1.00
Now a cost matrix of the expected cost
for each inventory policy can be de-
termined.
A policy of ordering two sets of spare
parts will minimize the expected cost for
spare parts where the refrigeration system
is installed.

TABLE 3

COST MATRIX

Failure
0 1 2 3 4
Or er Expected Cost

0 $ 0 $2,000 $4,000 $6,000 $8,000 $3,000

1 $ 500 $ 500 $2,500 $4,500 $6,500 $1,900

2 $1,000 $1,000 $1,000 $3,000 $5,000 $ 1,600*

3 $1,500 $1,500 $1,500 $1,500 $3,500 $1,700

4 $2,000 $2,000 $2,000 $2,000 $2,000 $2,000

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 Leininger 251

TABLE 4

OPPORTUNITY COST MATRIX COST SITUATION

Failure
0 1 2 3 4 Expected
Order Opportunity Cost

0 $ 0 $1,500 $3,000 $4,500 $6,000 $2,250

1 $ 500 $ 0 $1,500 $3,000 $4,500 $1,150

2 $1,000 $ 500 $ 0 $1,500 $3,000 $ 850*

3 $1,500 $1,000 $ 500 $ 0 $1,500 $ 950

4 j $2,000 $1,500 $1,000 $ 500 $ 0 $1,250

This type of problem requires another If a more rigorous approach to the

operational definition of opportunity
cost. Opportunity Cost (Cost Situation) is
the difference between the cost incurred
and the cost that would have been in-
curred if the correct policy had been
adopted.
Employing this definition, we can de-
termine the opportunity cost matrix and
the expected opportunity costs.
The policy that minimizes the oppor-
tunity cost is to order two sets of spare
parts. This is consistent with the results
obtained in cases in which the expected
costs were minimized.
problem is required, a general solution
of the static problem can be developed
for the four cases. Then it can be shown
that the opportunity cost solutions are
equivalent to the profit maximization
and cost minimization solutions. It is not
necessary to present the formal proof.
Students, in general, gain the necessary
insight into the meaning of opportunity
cost by participating in the solution of a
profit and cost problem as an in-class
exercise reinforced with several out-of-
class exercises.

REFERENCES

Burch, E. Earl and William R. Henry, "Opportunity and Incremental Cost: Attempt to Define in Systems
Terms: A Comment," THE ACCOUNTING REVIEW (January 1974), pp. 118-123.
Horngren, Charles T., Cost Accounting: A Managerial Emphasis, 3rd. ed. (Prentice-Hall, 1972).
Kohler, Eric L., A Dictionary for Accountants (Prentice-Hall, 1975).
McRae, T. W., "Opportunity and Incremental Cost: An Attempt to Define in System Terms," THE
ACCOUNTING REVIEW (April 1970), pp. 315-321.
"A Further Note on the Definition of Incremental and Opportunity Cost," THE ACCOUNTING
REVIEW (January 1974), pp. 124-125.
Samuelson, Paul A. Economics: An Introductory Analysis, 7th Ed. (McGraw-Hill, 1967).
Starr, Martin K. and David W. Miller, Inventory Control. Theory and Practice (Prentice-Hall, 1962).

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