Feature

By Mohamed E. Bayou, Ph.D., Alan Reinstein, CPA, DBA, and Gerald H. Lander, CPA, CFE, DBA

OPPORTUNITY
COSTS:
A Tool to Make Better
Business Decisions
Opportunity cost is ubiquitous since all aspects of life
involve opportunities. While some recent studies have
examined this concept, the opportunity cost concept
remains vague. Decision makers often ignore many
opportunity costs, as well as sunk and implicit costs in
making business decisions.
THE CONCEPT OF OPPORTUNITY COST
Economists and CPAs often view the opportunity cost
concept differently, with the former defining it more broadly
to encompass many types of costs, such as implicit costs not
included by the latter. The real economic costs of production
usually exceed the accounting costs of production because
economic costs include both explicit accounting costs and
opportunity or implicit costs; i.e., the value of the personal
resources the owners of a business make available (their labor
and capital). Thus, opportunity cost should be recognized and
realized when calculating the real (economic) costs, including
incremental costs. Companies may only maximize profits when
they recognize their real costs.
Austrian economists, particularly Ludwig Von Mises and
the London School of Economics, developed the opportunity
cost theory (Magni, 2009). Describing opportunity cost of an
investment as the income foregone if decision makers invest
their capital in different economic endeavors, Magni finds that
opportunity cost is income of a foregone opportunity. Thus,
it is a counterfactual income as opposed to the factual income
received (or to be received) in actual facts (Magnis emphasis).
Such opportunity costs include both financial and non-financial
components; i.e., income forgone and loss of leisure time,
respectively.
Unlike CPAs, economists include all aspects of cost to derive
opportunity costs. Kohler defines cost as an economic sacrifice
occurred in exchange to acquire an object. While CPAs define
cost of an object as a sacrifice of property obtained through past
transactions, economists define cost of an object as a sacrifice of
a potential property obtainable through a future transaction(s)
of a foregone opportunity. Financial accounting does not
record opportunity costs in financial records since doing so
would violate the cost principle of goods not actually changing
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masters. Accountants consider opportunity cost as a derived

concept of the more general concept of cost, while economists
consider all costs as opportunity costs.
EXAMPLES OF APPLICATIONS OF ACCOUNTING
AND ECONOMIC OPPORTUNITY COSTS
Measuring labor costs for various market conditions
and types of jobs should consider special labor market
characteristics, including such direct factors as income taxes
and unemployment insurance compensation, plus such
indirect factors as job quality and the nature of the workers
unemployment. Generally, CPAs would consider only the direct
measurable costs, while economists would also consider the
indirect factors.
Next, resources used to assess healthcare costs should
include economic opportunity costs that should consider
difficult-to-measure indirect effects, such as costs of patients
waiting while non-insured folks use scarce emergency rooms
(Robinson, 1993), and which CPAs generally do not measure
(Dawson, 1994). CPAs need comprehensive, disaggregated
data at the individual patient level to measure opportunity
costs, and allocating overhead and fixed costs is difficult given
the problems of ascertaining the cause and effect relationships
between resources and different users. Pharmaceutical
product prices also often ignore opportunity costs since
retail prices reflect the patent, government regulated profits,
and sunk research and development costs of both successful
and unsuccessful products. Thus, few studies estimate the
opportunity costs of drugs, relying instead on prices.
Also, valuing resources when no market exists, such as
informal care or patient time costs, requires methods to derive
what economists call shadow prices the true social value
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(or opportunity cost) of non-marketed resources, such as time

and informal care. Health accountants and economists often
disagree about proper techniques to measure the opportunity
cost of time; for example, the best valuation of the opportunity
cost of time for working age adults is the wage they are, or could
be, making in paid work, varying according to whether the time
lost involves lost work or leisure time, or the likelihood of being
unemployed.
Economists view opportunity costs as inapplicable in
situations when decision makers must follow specific
alternatives, as when Toyota follows a centralized approach
to decision-making regarding major plant infrastructure.
Business-unit managers lack autonomy to make such decisions
since the decision is imposed in a top-down managerial
hierarchy. Knight, an economist, explains that, where there
is no alternative to a given experience, no choice, there is
no economic problem, and cost has no meaning. But, as
shown below, such uncontrollable costs can be meaningful for
managerial performance purposes.
Net opportunity cost is the difference between income of an
alternative and the income of the best alternative (opportunity).
Thus, when investors and other decision makers select the best
economic alternative (investing capital in Project A or Project
B), they should use the net opportunity cost (NOC) concept, as
Equation 1 shows.
NOCi = Best alternatives income Alternative is income (1)
where, NOCi = Project is net opportunity cost. Hence, if project
A has the highest income, Bs and As net opportunity costs are:
NOCB = Income from project A Income from project B =
IA - IB
NOCA = Income from project A Income from project A =
IA IA = Zero
Thus, selecting the best opportunity out of a set of mutually
exclusive opportunities entails no net opportunity cost for an
investment decision.
Opportunity costs also relate to accepting specially ordered
projects. For example, if I A= $10 and IB = $8, Project As net
benefit = Income from Project A Opportunity Cost (of not
investing in IB) = $10 - $8 = $2. Also, Project Bs net benefit
= IB Opportunity Cost (of not investing in Project A) = $8 $10 = $(2). Now, if the firm were offered a special sales order,
that would generate a $10 contribution margin [CM] (sales

less variable costs). Accepting the special order uses capacity

available to generate $12 of CM for increased production of
Product A. The net benefit of accepting the special sales order
would thus equal the special orders CM minus the related
opportunity cost = $10 - $12 = ($2). In the short-term, the
firm would reject the special order at the proffered price, but
it should also consider such other factors as could it sell more
units of Product A and the additional selling costs of doing so.
The opportunity cost concept focuses on subjective
opportunities, as decision makers have different opportunities
and evaluate differently their attached values. Opportunities can
be actual or potential. Actual opportunities are now available
for decision makers. Potential opportunities are a product of
imagination that may become relevant in such major decisions
as committing to a long-term contract, changing ones location
of living, career and marital status.
Opportunity cost can either be unconditioned or conditioned.
UNCONDITIONED OPPORTUNITY COST
When decision makers are not currently committed (no
sunk cost), opportunity cost is described as unconditioned.
However, when considering a choice of actions, three issues
arise: (1) define all alternative opportunities; (2) measure the best
of these alternative opportunities; and (3) measure the gains in
selecting the best alternative opportunity instead of the selected
choice which is the opportunity cost (Alden, 2005, p.1).
Ignoring the often hidden indirect costs of interest to
economists, to illustrate, in purchasing real estate, a decision
maker can select among four mutually exclusive alternatives,
A-D (see Table 1). After calculating net benefits, the computed
gross amounts of each alternatives opportunity cost are $20,000,
$30,000, $40,000 and $50,000 for alternatives A-D, respectively,
as shown in Panels A of Table 1. Panel B shows the net
opportunity cost of each alternative as the difference between
the gross opportunity cost of the best alternative ($50,000 of
alternative D as shown in Panel A) and the gross benefits of
each alternative. Thus, the net opportunity cost of alternatives
A-D are $30,000, $20,000, $10,000 and $0, respectively, which
equal the net benefits from Panel A less Alternative Ds gross
opportunity costs.
continued on next page

Table 1
Unconditioned Opportunity Cost: An Illustration
Panel A
Gross benefits
Costs (assumed equal for simplicity)
Net benefits (gross opportunity cost)

Relevant Opportunities
A

$90,000
70,000
$20,000

$100,000
70,000
$30,000

$110,000
70,000
$40,000

$120,000
70,000
$50,000

Panel B
Best alternatives net benefits
Net benefits (gross opportunity cost)
Net opportunity costs
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Relevant Opportunities
A

$50,000
20,000
$30,000

$50,000
30,000
$20,000

$50,000
40,000
$10,000

$50,000
50,000
$ 0
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Opportunity Costs
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Table 2
Conditioned Opportunity Cost: An Illustration
Panel A

Relevant Opportunities

$90,000
(70,000)
$20,000
(25,000)

(The Current
Commitment)
B
$100,000
(70,000)
$30,000
0*

$110,000
(70,000)
$40,000
(25,000)

$120,000
(70,000)
$50,000
(25,000)

($5,000)

$30,000

$15,000

$25,000

A
Gross benefits
Less: Costs (assumed equal for simplicity)
Subtotal
Less: Uncovered sunk cost of B
Net benefits (gross opportunity cost)

*Alternative B is the current commitment, whose related sunk costs are not affected unless the decision makers
switch to another alternative.

Panel B

Relevant Opportunities

A
Best alternatives net benefits
Less: Net benefits
Net opportunity costs

$30,000
(5,000)
$35,000

Decision: Select Alternative D, which has the least amount of

net opportunity cost.
Table 1 quantifies all four alternatives benefits and costs; the
best choice is real estate D, which has the least amount of net
opportunity cost (i.e., $0). In short, when decision makers do
not consider switching from a current existing commitment
to a new alternative, opportunity cost is unconditioned and its
application is straightforward, as illustrated in Table 1.
CONDITIONED OPPORTUNITY COST
The study next examined the effects of a currently
committed decision maker, i.e., who has placed sunk costs into
the project, who considers switching to a new alternative. The
sunk cost of the current commitment will not be altered as a
result of a decision that will change business activity (Henry
and Burch, 1974). However, many decision makers consider
cost recoverability. The organization behavior literature has
many studies about escalation of failed commitments (Staw,
1981; Staw and Ross, 1988). Decision makers often are (overly)
committed to unrecovered parts of sunk cost, and may make
switching to a new alternative less preferable, as part of their
personal learning curves. Given that the company is now
committed to Project B, Table 2 illustrates this conditioned
opportunity concept.
Decision: Select Alternative B since it has the least amount
of net opportunity cost; that is, maintain the status quo by not
replacing real estate B.
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(The Current
Commitment)
B
$30,000
30,000
$ 0

$30,000
15,000
$15,000

$30,000
25,000
$5,000

Per Table 2, the best alternative is B, maintain the status

quo and keep alternative B. The recent U.S. cash-for-clunker
program illustrates the importance of sunk cost recovery
in decision making. This government program paid about
$4,500 to transfer ownership of each old car (clunker) to the
government to stimulate automobile sales. CNN Money (March
9, 2010, p. 1) found that 30 percent of polled customers who
used this program had no intentions of buying a new car, but
said they bought one because the government program was too
good to pass up. (So, basically, the program was a giveaway to
the 70 percent who would have bought a car anyway.) While
this credit reduced the cost of a new car, many customers also
viewed the $4,500 as a sufficient recovery of the sunk cost
invested in a clunker. This program temporarily strengthened
but cannibalized future auto sales. When this program ended
in August 2009, General Motors, Ford and Chrysler all reported
that September sales were down more than 30 percent from
August (The American, June 29, 2010).
In summary, the essential question relevant to a decision
making situation is not whether the past commitment can be
reversed, but rather, it is how much is recoverable from the sunk
cost in this commitment; that is, focus on cost recoverability
rather than commitment reversibility.
ISSUES IN USING OPPORTUNITY COST MODELS
Transfer prices (TP) apply many different opportunity cost
models that a number of company personnel often do not
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recognize. Holstrum and Sauls denote four commonly used

methods to calculate opportunity costs to set transfer prices,
average variable cost, full cost, market price, and managementnegotiated prices. While the first three methods often fail to
yield goal congruence, the fourth, negotiation, helps to measure
the managers performance a function of production and
negotiation ability. However, a negotiated transfer price does not
always lead to goal congruence, requiring central management
to generate data independently and audit division-provided data.
Holstrum and Sauls conclude that when the transfer price is set
by central management at the point at which the opportunity
cost of the distributing division equals the opportunity cost of
the manufacturing division, both divisions will be encouraged to
produce that quantity that would be optimal for the firm.
Also, Onsi discusses using opportunity costing with
decentralized decision making and creating multi-product
organizational profit centers, a potential problem in assessing
divisional managers performance and incentive compensation
based on profit. Assuming that MCa (marginal variable costs
of Division A) = NMRb (net marginal revenue of Division B),
the supplying profit center is not motivated to change the relative
use of various factors of production in response to changing
factor prices, since these favorable effects will pass over to the
buying profit center. The profit center selling the final product
will be motivated to manipulate its sales by delaying them into
next year, if this year is especially profitable, or to increase its
production inventory to capitalize more of its overhead, leading
to increased profit if it is originally unfavorable. This affects the
production of intermediate goods.
The corporate level should thus monitor inventory levels
(similar to Holstrum and Sauls approach) to help prevent this
from occurring. Also, buying divisions could commit themselves
to purchasing a certain volume. For a fairer profit distribution,
profit center A should be given the profit foregone (motivational
cost) from producing X1 and selling it to profit center B. Onsi
factors in this motivational cost to reduce conflicts among
profit centers, which Benke et al, call the lost contribution
margin, also called the opportunity cost.
Benke et al. propose a general approach to transfer pricing
that shows companies how to determine a transfer price that will
promote neoprofit (which is subject to ever changing constraints,
business moves toward achieving the maximum profit), and
enhanced performance evaluation. They also propose an
opportunity cost general rule for transfer pricing, where the
transfer price should equal the standard variable cost (SVC)
plus the contribution margin per unit given up (CMGU) on the
outside sale by the company when a segment sells internally.
Thus, relevant costs equal out-of-pocket (i.e., variable) costs
plus opportunity costs. The CMGU is the lost contribution
(LCM), so the TP = SVC + LCM. The lost contribution margin
(opportunity cost) is the difference between the external market
price of the intermediate product and the SVC. Benke et al.
suggest that smaller companies may need to apply the general

rule differently than their larger competitors, as when a small

company views an oligopolistic market as being perfectly
competitive.
Next, Feldstein views the social opportunity cost (SOC) of
a public investment project as the value to society of the next
best alternative use to which the resources employed in the
project could have derived, also discussing such rates as the
Marginal Rate of Social Productivity of Private Investment, and
the Weighted Average Rate of Return. He shows that the correct
measure of the social opportunity cost of a public project is the
discounted value of the consumption stream that would have
occurred had the project not been undertaken. He discounts
this present value at the social time preference (STP) rate, a
normative rate reflecting the governments evaluation of the
relative desirability of consumption at different points in time.
The estimated forgone consumption stream should reflect the
source of funds, the productivity of private investment, and the
effects of taxation and reinvestment.
APPLYING ACCOUNTING OPPORTUNITY COSTS
FOR BUSINESS DECISIONS
FOCUS ON FOREGONE PROFITS
Assume a company with a huge backlog of orders for a product
that uses a critical machine that generates revenues of $1,000
per hour, but incurs incremental costs and expenses of $400,
deriving $600 per hour of contribution margin. Also assume that
an employee failed to perform a routine maintenance task that
caused the machine to shut down for 10 hours, and the repair
bill (repairs and maintenance expense costs) to fix the machine
was $800. But, the company also lost $6,000 (10 hours x $600 per
hour) in operating or pre-tax income.
This example derived $6,000 of opportunity cost of lost profits,
ignoring the costs of lost or upset customers. However, if the
machine were not critical to manufacturing the product or no
backlog of orders arose, no foregone profits or opportunity costs
would arise (Averkamp, 2011).
TRANSFER PRICING EXAMPLES
Drury states that the transfer price should equal the marginal
(variable) cost to produce the transferred product or service,
plus the opportunity cost of making the transfer. This point is
illustrated by adapting Curries hypothetical Glass Co example.
The illustration uses PlastiCo that has a Molten Plastic Division,
whose summary of annual activities appear below.
PlastiCo also has a Plastic Bottles Division that needs 20,000
tons of molten plastic per year to manufacture its bottles. This
division currently buys all of its molten plastic from an external
supplier for $210 per ton; it can continue using its current
supplier, or buy its supplies from PlastiCos Molten Plastic
Division.
First, if the Molten Plastic Division could not increase its
output above 80,000 tons per year, all products sold to the

Molten Plastic Division

Output and sales
(all to external customers)
80,000 tons

Selling price
$240 per ton

Marginal cost
(= variable cost)
$130 per ton

Fixed costs
$1,480,000 per year

continued on next page

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Opportunity Costs
continued from page 25

Plastic Bottles Division would reduce external customer sales.

Thus, its relevant cost to produce molten glass = $130 per ton
(given), plus the opportunity cost to make the transfer (= lost
contribution from foregoing the sale to the external customer =
[$240 selling price - $130 marginal cost] = $110 per ton). Thus,
the minimum transfer price = [Marginal cost incurred up to the
point of transfer] + [Opportunity cost of making the transfer]
= $130 + $110 = $240 per ton. The Molten Plastic Division
also would not want to transfer its product for under $240,
which would reduce the divisions profits. The Plastic Bottles
Division will not pay more than $210. PlastiCos profits will be
maximized by not transferring products.
If the Molten Plastic Division has the capacity to increase its
output above the current level of 80,000 tons per year, but incur
no additional fixed costs and retain the $130 per ton of variable
costs, and with no other external demand for its product, it
could produce some extra molten glass for the Plastic Bottles
Division without affecting its external customers. Its new
REFERENCES
Alden, Lori, 2005, Opportunity Cost, A Primer, retrieved October 8, 2012
from www.econoclass.com/opportunitycost.html, pp. 1-6.
Averkamp, Harold, 2011, Would You Please Help Me Understand
Opportunity Cost? Retrieved November 4, 2012, from http://blog.
accountingcoach.com/opportunity-cost.
The American, June 29, 2010, Cash for Clunkers: A Retrospective,
retrieved October 8, 2012, from http://american.com/archive/2010/june-2010/
cash-for-clunkers-a-retrospective.
Benke, Ralph L. Jr., James Don Edwards and Alton R. Wheelock,
1982, Applying an Opportunity Cost General Rule for Transfer Pricing,
Management Accounting, June, pp. 43-51.
Blocher, E. J., D. E. Stout, P. E. Juras and G. Cokins, Cost Management: A
Strategic Emphasis, 6th ed. (NY: McGraw-Hill/Irwin, 2013).
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CNN Money, March 9, 2010, Cash for Clunkers, Better Than We Thought,
retrieved October 8, 2012 from http://money.cnn.com/2010/03/09/autos/
clunkers_analysis/index.htm.
Currie, J. 2006. Transfer Pricing. Retrieved November 4, 2012 from http://
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Dawson, D. 1994, Costs and prices in the internal market: markets
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Drury, C. 2004. Management and cost accounting (6th ed.). Thomson.
Feldstein, Martin S., 1964, Opportunity Cost Calculations in Cost-Benefit
Analysis, Public Finance, pp. 117-139.

calculations become, first, the relevant (variable) cost to

produce molten glass = $130 per ton; no opportunity costs
to make the transfer exists; and the minimum transfer price
equals $130 per ton. The Molten Plastic Division manager
can negotiate a price between $130 and $210 per ton to help
maximize both divisions profits and yield goal congruence for
PlastiCo.
RECOMMENDATIONS
CPAs, their employers, clients and other decision makers
should consider the economic or accounting opportunity
cost model to make major decisions, using Excel or other
spreadsheet programs. While they both would use similar
methodologies to consider sunk costs and to calculate
opportunity costs, unlike CPAs, economists would consider
the indirect costs of their decisions. They would state that after
all, managerial decision making should consider all relevant
economic costs. 

Holstrum, G. L, and E. H. Sauls, 1973, The Opportunity Cost Transfer

Price, Management Accounting (May): 29-33.
Hoskin, Robert E., Spring 1983, Opportunity Cost and Behavior, Journal
of Accounting Research, pp. 78-95.
Jenkins, Glenn 1995. Economic Opportunity Cost Of Labor: A Synthesis,
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Knight, Frank Hyneman 1935, The Ricardian Theory of Production and
Distribution (Chicago: University of Chicago Press)
Kohler, E. L. 1963. Why Not Retain Historical Cost? Journal of
Accountancy, 116(4), 35-41.
Koopmanschapp, MA, and F. H. Rutten 1996, A practical guide for
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Magni, C.A. 2009. Splitting up value: a critical review of residual income
theories. European Journal of Operational Research (198, 1): 1-22.
McRae, T.W., 1970, Opportunity and Incremental Costs: An Attempt to
Define in Systems Terms, The Accounting Review, April, Vol. 45, No. 2, pp.
315-321.
McRae, T.W., 1974, A Further Note on the Definition of Incremental and
Opportunity Cost, The Accounting Review, January, Vol. 49. No. 1, pp. 124125.
Monden, Y., 1993. Toyota Production System, An Integrated Approach to
Just-In-Time. Second Edition. Industrial Engineering and Management, Press
Institute of Industrial Engineers.
Onsi, Mohamed, A Transfer Pricing System Based on Opportunity Cost,
July 1970, The Accounting Review, Vol. 45, No. 3, pp. 535-543.
Staw, B. 1981. The escalation of commitment to a course of action,
Academy of Management, 6 (October): 577-587.
Ross, J. 1988. Good money after bad, Psychology Today, 22, 2 February:
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Stiglitz, JE, 1986, Economics of the public sector. New York: Norton; 1986.
Robinson R., 1993, Costs and cost-minimization analysis. BMJ.1993; 307:
726728.

Mohamed E. Bayou, Ph.D., is Professor of Accounting in the College of Business, University of Michigan-Dearborn. He may be reached at mbayou@
umd.umich.edu. Alan Reinstein, CPA, DBA, is George R. Husband Professor of Accounting in the School of Business at Wayne State University. He
may be reached at a.reinstein@wayne.edu. Gerald H. Lander, CPA, CFE, DBA, is Gregory, Sharer and Stuart Professor Emeritus at the University of
South Florida-St. Petersburg. He may be reached at lander@mail.usf.edu. The authors would like to express appreciation to Dave Stout (Youngstown
State University) and Phil Beaulieu (University of Calgary).

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