Opportunity cost refers to the cost which an individual or company forgoes by selecting one outcome or course of action and rejecting the other outcomes or course of action. Hence for example, if an individual has $1000 and he or she has two options one is to buy a mobile and other is to give a party to his or her friends now if an individual decides to give a party to friends than the opportunity cost of giving party is the mobile which an individual could have purchased if he or she does not have given party to his or her friends. In order to understand more about this concept, one should look at the advantages and disadvantages of opportunity cost –
Advantages of Opportunity Cost
Evaluation of Various Alternatives
One of the advantages of opportunity cost is that it helps in the evaluation of various alternatives which in turn helps in making a better decision. Hence for example, if the company has $500000 and the company wants to invest that money in some profitable project and company has three options out of which one option is giving $20000 profit in one year while other two options are giving $25000 and $18000 profits than the company will select the project having a profit of $20000 then the opportunity cost of selecting a project is $25000. In doing opportunity cost analysis the company has evaluated all three projects and thus has data of all three projects and not 1 project.
Identification of Relative Profitable Opportunity
Another benefit of opportunity cost is that while evaluating various alternatives the company finds other profitable projects also which company can undertake in the future. In simple words, if in a treasure hunt you are searching for gold and you find silver than although your priority is gold and if you have taken gold in your bag and there is some space than you will also put silver in your bag, in the same way, the company will invest funds in the most profitable project and if it has some funds left than it will invest money in alternative projects also.
Dress Rehearsal
Another benefit of opportunity cost is that in a way it is dress rehearsal because while doing this analysis company tries to emulate real project to find out the relative importance of each project and hence if some mistake is there than it can be found during opportunity cost analysis rather than during actual project implementation and hence the company is saved from embarrassment during actual project implementation.
Disadvantages of Opportunity Cost
Time Consuming
The biggest disadvantage of opportunity cost is that it is time-consuming because the evaluation of various projects requires time on the part of the company and it cannot be done overnight resulting in delays in the execution of projects and in this age of cut-throat competition companies cannot afford to delay projects as chances of competitors entering and taking away the advantage of the project from the company is more. In simple words suppose you are planning to watch a movie and there are 3 movies and if you keep thinking about which movie to go then chances are that all shows will be booked and you will have no option but to go home in the same way company should not take too much time in analyzing the opportunity cost of different projects.
Unproductive
It is an unproductive exercise in the sense that it does not help in increasing the productivity of the company because this analysis only helps in understanding whether or not the project is attractive as compared to other projects but it does not throw any idea on how to do the project quickly and efficiently. In simple words, if you want to go from one place to another then merely looking at various modes of transport is not enough rather you have to take one mode of transport in order to reach to your destination same is the case with the companies where merely looking at opportunity cost is not enough rather company has to take the decision and execute the project at earliest.
Subjective
Another problem with this analysis is that sometimes it can be subjective in the sense that the same project viability can be viewed differently by different persons and thus bring subjectivity into play resulting in opportunity cost losing its relevance. In simple words, if a person is going to watch a movie than the person who loves to watch horror will go for horror even though a comedy movie is better than a horror movie, same is the case with the project where if management loves some project than he or she will select that project only even though opportunity cost of doing that project is not in favor of that project.
As one can see from the above that the opportunity cost has benefits as well as limitations and that is the reason why any company using it for evaluation purpose should carefully consider the above points and then take the decision accordingly.