What is Opportunity cost and why is it a Relevant cost as well?

Opportunity costs are defined to be the economic value of the benefit sacrificed under one alternative to avail the benefit under another alternative course of action.

For example, company have the option of manufacturing either alpha or beta. As company does not have enough resources to manufacture both of them so it will have to choose one of them. Suppose alpha is expected to render Rs. 10/unit where beta is expected to earn Rs. 8/unit. Definitely, based on this information, company will go with product alpha as it is rendering more profit per unit. But in order to earn Rs. 10 profit company has sacrificed Rs. 8 profit. In other words cost of earning 10 rupees is 8 rupees.

Let’s take another example to understand why opportunity costs are treated as relevant costs and is included as cost in many decision making situations even though these are not actual costs.

A company is approached by a customer who wants to place an order for certain goods. Company is currently engaged in manufacturing one of its own product. Due to limited machine capacity only one type of item can be produced at a time i.e. either customer’s product or company’s product.

In the above example if company accepts the customer order then it will have to stop the production of its own product and thus will sacrifice the profit that it was earning or can earn by selling its own product. This amount of profit sacrificed is the cost of accepting customer’s order. And this sacrifice should be included in the production cost of customer’s order because company has abandoned its own product and thus is at “loss” by not producing its own product as company will stop producing and selling its own product and thus no profit from its own product. And this “loss” should be recovered from customer. And if customer is not willing to pay enough price that can also cover the sacrifice of existing profits than it is not fruitful to accept the customer’s order.

This “loss” is dependent on the company’s decision i.e. if customer accepts the order then profit on own product will be foregone and if customer’s order is rejected then company will keep on earning its original profit. Therefore, it is a relevant cost. We can also understand how opportunity costs are also relevant costs by putting the opportunity cost accepting customer’s order in our example against the basic three points criteria of relevant cost.

1. Relevant cost is a future cost. The loss of profits will happen in future if production is stopped.
2. Relevant costs consists of actual cash flows. Company receives cash by selling its product and if production is halted this cash flow will also stop.
3. Relevant costs are dependent on the decision. The loss of existing profits will occur only if customer’s order is accepted.

Opportunity cost is also named as implied or implicit cost. Sometimes it is also termed as notional costs but not all notional costs are opportunity costs and care should be taken while categorizing a particular cost.