What is the difference between Notional cost and Opportunity cost?

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Notional costs and Opportunity costs are two important concepts in cost and management accounting as they have far reaching effects on decisions making process. But both are distinct and understanding the features of each type of cost is vital as it has important implications from decision making perspective.

All opportunity costs included in the cost for decision making purposes are always notional costs but all the notional costs that might have been included in the cost might not be opportunity costs as well. In simple words all opportunity costs are notional costs but not all notional costs are opportunity costs.

Notional cost is any imaginary cost that have been included in the cost for decision making purposes. But opportunity cost is NOT just any imaginary cost. Opportunity cost arises only when one course of action has been selected and because of that benefits that were available under other alternatives have been foregone.

Let’s understand it with an example.

Company owns a piece of land and have used it to install a production machinery on it.

Now every unit that is being produced will not have rental cost included in it as company is not incurring any cost towards rent. But if company wants to compare its product’s performance with the one of its competitor’s product and if that competitor is incurring a rental cost then to make the comparison “fair” then company might add an imaginary rental cost in the production cost. As this is mere imagination and company is not actually incurring any cost towards rent thus the name notional which also means imaginary.

Opportunity cost will only arise and will be included in the cost of production when company had the option to rent out the land and someone was willing to pay the rent as well i.e. company had the second alternative of letting it instead of using it for production purposes then such notional rental cost (that is equivalent of expected rent that can be earned by renting out this land) will be an opportunity cost as well. But if there was no one who was willing to hire this land for rental purposes and thus if company has not sacrificed any benefit under another alternative then there will be no opportunity cost and rental cost that will be added will be just notional cost.

Many students confuse notional cost with opportunity cost but the difference is evident and clear. The scope of notional costs is much wider than of opportunity costs.

3 COMMENTS

    • An entity can have a specific formula or mathematical expression to determine notional cost based on its policies but on conceptual level it doesn’t have any associated formula as a standard.

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