Opportunity Cost and Actual Cost

Opportunity Cost and Actual Cost

Opportunity cost is the loss incurred due to the unavoidable situations such as scarcity of resources. If resources were unlimited, there would be no need to forego any income yielding opportunity and, therefore, there would be no opportunity cost. Resources are scarce but have alternative uses with different returns, Resource owners who aim at maximising of income put their scarce resources to their most productive use and forego the income expected from the second best use of the resources. Thus, the opportunity cost may be defined as the expected returns from the second best use of the resources foregone due to the scarcity of resources. The opportunity cost is also called the alternative cost.

For example, suppose that a person has a sum of Rs. lOO,OOO for which he has only two alternative uses. He can buy either a printing machine or, alternatively, a lathe machine. From printing machine, he expects an annual income of Rs. 20,000 and from the lathe, Rs. 15,000. If he is a profit maximising investor, he would invest his money in printing machine and forego the expected income from the lathe. The opportunity cost of his income from printing machine is,· the expected income from the lathe machine, i.e., Rs. 15,000. The opportunity cost arises because of the foregone opportunities. Thus, the opportunity cost of using resources in the Printing business is the best opportunity and the expected return from the lathe machine is the second best alternative. In assessing the alternative cost, both explicit and implicit costs are taken into account.

Associated with the concept of opportunity cost is the concept of economic rent or economic profit. In our example, economic rent of the printing machine is the excess of its earning over the income expected from the lathe machine (i.e., Rs. 20,000 – Rs. 15,000 = Rs. 5,000). The implication of this concept for a businessman is that investing in printing machine is preferable as long as its economic rent is greater than zero. Also, if firms have knowledge of the economic rent of the various alternative uses of their resources, it will be helpful for them to choose the best Investment A venue. In contrast to opportunity cost, actual costs are those which are actually incurred by the firm in the payment for labour, material, plant, building, machinery, equipments, travelling and transport, advertisement, etc. The total money expenditures, recorded in the’ books of accounts are, the actual costs, Therefore, the actual cost comes under the accounting concept.