Opportunity cost for decision making: A teaching resource to describe the difficulties of practice INTRODUCTION

The difficulties associated with the use of opportunity cost as a decision making aid are generally not discussed in the management accounting related texts. But most of the new management texts devote at least some coverage to the calculation of relevant cost and benefits for the decision making, and commonly the concept of opportunity cost is utilized as an integral part of this coverage. Opportunity cost is defined by many of the economists, but the main focus of every one of them is on the “contribution or profit that is forgone (rejected) by using limited resources for particular purpose”. OC remains at the heart of study of decision making today, it being seen as useful both in the calculation of merit of competing alternatives and as a way describing the preferred alternatives. This research paper comprises of following parts: • Strengths and Limitation of Opportunity Cost. • A worked example that illustrate the difficulties which may limit OC as a practical decision aid. An alternative cash flow approach that overcome the difficulties by the use of OC approach. • Discussion and Conclusions.

As a decision making aid, OC is commonly seen to have three areas of strength: 1. It forces consideration of all alternative course of action 2. It is a convenient, expedient and economical technique of analysis 3. It has certain communication advantages. It can highlight the overall benefit of a particular decision. Exploring of the above strengths are as follows:  Decisions are concerned with choices between alternatives and, consequently, any method of determining costs and revenues for decisions which attempts to deal with opportunities in isolation is unlikely to provide a complete analysis. The main importance of the opportunity-cost concept is that it forces the decision maker to consider all alternatives. This has important information implications in that decision makers need to be aware of alternatives and their consequences, and not just within their own area of responsibility. Assuming this to be possible, OC does highlight the need for a comparison of all alternatives. It is difficult to imagine, however, any sensible approach to decision making that does not emphasize every close alternative as being a possibility.  The use of opportunity cost is justified on the grounds that many alternatives will be rejected outright without a formal analysis. It needs to be realized, however, that although OC may occasionally offer such a short cut in calculation; a corresponding danger is the potential not to consider the whole problem. In other words, techniques which offer supposed short cuts may also have the concomitant effect of not giving full consideration to the complexities of possible cost behaviour and revenue patterns.  The positive ‘profit’ implies that the alternative not only adds to a company's net cash resources but is better than competing alternatives. Although this information may, in some cases, be extra then needed it may, in others, enhance the role of the accountant as a communicator of information for decisions. Thus OC may be used as a behavioral tool to communicate the benefits of certain courses of actions. However, given that OC must in part reflect the circumstances consider by the decision maker and his/her attitude to risk, OC might just add another dimension of complexity. Although all evaluation tools suffer at the hand of an uncertain future, such problems may well be heightened in the case of OC. In

Yellik Ltd has recently received a £90 000 contract proposal company would a unique component of Burley Brothers. To rank alternatives a business person would need to know the OCs of the alternatives. As it stands. it may well be extra then needed in reaching a decision. it may have limitations from a practical business perspective.other words. Furthermore. The following additional information is available: 1. Indeed. costs of £500 would have to be .000 two years ago for a similar contract proposal that was not undertaken. A solution to Yellik Ltd using an OC approach is then derived. YELLIK Ltd. Material A was bought for £20. especially in its emphasis on the need to consider alternative courses of action when making a decision. thus to find the OC of alternatives there is a prior condition of ranking them. organizations may struggle to even recognize what constitutes a best alternative. he/she would first have to know their values. we will use a decision context that is commonly used to introduce the use of OC for decision making purposes namely. The contracts office has put together estimates indicating should not be accepted. following which an alternative incremental cash flow approach is presented.contract estimates. but which has resource implications elsewhere in the organization. a special contract which enables an organization to utilize some existing spare capacity. and its potential pitfalls discussed. however. never mind quantify how much better it is than the next best alternative. AN EXAMPLE OF THE USE OF OPPORTUNITY COST: To illustrate some of the possible problems which may be associated with the practical use of OC. but to know the OCs of the alternatives. hence making OC extra then needed to the decision process. under which the facilities which at completed in six that the contract Yellik Ltd . Employing present are manufacture underutilized the special contract can be months. even in those situations where OC could be calculated. Thus what is being argued is that although OC has a number of strengths. the material is of no immediate use to Yellik Ltd and has zero re-sale value.

2.solution using an opportunity cost approach Yellik Ltd-solution using an incremental cash flow approach . The stock of material A would be exhausted by the current contract.600. her time lost on that work being made up by paying overtime costing £3. for any reason. However.000 if used on the contract. material A would first require treatment and conversion at a cost of £2. It should therefore be treated as a variable cost.000 per quarter. 3. Direct labour will be sub-contracted to outside suppliers and paid on a piecework basis. At present it could be sold for £20. it could be used in a few months time in connection with a factory extension as substitute for certain pre-fabricated supports which would cost £16. Her salary is £12.000. 5. In six months time its re-sale value is expected to decline to around £15. An administrator would be needed to co-ordinate the contract.000.000. In this case. the material would have a re-sale value of £11. Its expected useful life was five years. Yellik Ltd . 6. If the company takes delivery. Alternatively. a part of the factory could be sub-let to a local repair and maintenance business for £7. Yellik Ltd cancels the order. if Yellik Ltd does not proceed with it.000. The equipment which would be used for the proposed contract was purchased a few years ago for £70. The £8000 fixed overheads represent an allocation of general factory costs that would remain unchanged whether or not the contract is undertaken. Material B is a very scarce resource which has therefore already been ordered by the firm at a price of £15. 4.000 per annum. then a 20% cancellation charge will apply.000.000. She could be seconded from her normal work as a draughtsperson. If.incurred in order to dispose of it. Yellik Ltd is committed to paying this sum on delivery.

this seems less attractive than it did before since it only represents an 11% increase on the amount that can be gained now as a result of not accepting the contract. not in relative terms. The non-observability of OC was argued to make it difficult to control and monitor decisions based on its use. or not to go ahead with it. . to go ahead with the contract. however. but it also answers the first three criticisms discussed earlier. ♦ ♦ ♦ However. To do this it will be necessary to revert to a separate analysis of annual cash flows. The opportunity cost approach only gives an answer in absolute terms. ♦ The opportunity costs in the statement do not necessarily represent actual cash flows. without reverting to the separate consideration of individual cash flows.The opportunity cost approach to assessing relevant costs and benefits for the decision at hand demonstrates (correctly) that the contract yields a net benefit of £5000. 1. Where projects extend over more than one year (as is frequently the case). DISCUSSION AND CONCLUSION: The motivation for this article has been to examine some of the possible limitations of using OC as a practical decision aid. 2. that is. it would normally be appropriate to employ some discounting technique to take account of the time value of money. The benefit from accepting the contract is an increase in net cash flow of £5000 as before. would seem to be constrained by at least four limitations. Four separate issues have been raised and illustrated through the example. in terms of those cash flows which change as a result of the action proposed. Yellik Ltd. The practical usefulness of this approach in business contexts. This may not be sufficient compensation for the extra uncertainty involved in undertaking the contract. the incremental cash flow approach not only resolves this fourth limitation leveled at the opportunity cost approach. There were only two alternative overall courses of action in the Yellik Ltd illustration. Interestingly. The notion of OC cannot allow for the timing of cash flows in situations where the projects under consideration extend over more than one year.  This can only be resolved by re-evaluating the contract in terms of incremental cash flows for the two alternatives.

. and so helps achieve the key learning objective that students are able to identify relevant costs and benefits for decision making. 4. It has the merits of clarity and simplicity. The incremental cash flow approach has been found to be extremely helpful in reducing the confusion that students often suffer when studying opportunity costs. Where several alternatives are under scrutiny. the identification of the appropriate base case might be non. and is consistent with the approaches normally adopted in other areas of management accounting such as budgeting and investment appraisal. The incremental cash flow framework could then be introduced as a technique which resolves the key issues rose like difficulties in using Opportunity Cost approach.trivial and thus create difficulties in the calculation of OC. OC leads to the evaluation of overall benefits that are difficult to assess in terms of the original projects.3. The above limitations and the example discussed in the text illustrate why the use of an incremental cash flow approach to the analysis of business decisions might be beneficial.