Opportunity cost for decision making: A teaching resource to describe the

difficulties of practice

INTRODUCTION:
The difficulties associated with the use of opportunity cost as a decision making aid
are generally not discussed in the management accounting related texts. But most of the
new management texts devote at least some coverage to the calculation of relevant cost
and benefits for the decision making, and commonly the concept of opportunity cost is
utilized as an integral part of this coverage.
Opportunity cost is defined by many of the economists, but the main focus of every
one of them is on the “contribution or profit that is forgone (rejected) by using limited
resources for particular purpose”.
OC remains at the heart of study of decision making today, it being seen as useful
both in the calculation of merit of competing alternatives and as a way describing the
preferred alternatives.

This research paper comprises of following parts:

• Strengths and Limitation of Opportunity Cost.
• A worked example that illustrate the difficulties which may limit OC as a practical
decision aid. An alternative cash flow approach that overcome the difficulties by
the use of OC approach.
• Discussion and Conclusions.

STRENGTHS AND LIMITATIONS OF OPPURTUNITY COST:

As a decision making aid, OC is commonly seen to have three areas of strength:
1. It forces consideration of all alternative course of action
2. It is a convenient, expedient and economical technique of analysis
3. It has certain communication advantages. It can highlight the overall benefit of a
particular decision.

Exploring of the above strengths are as follows:

 Decisions are concerned with choices between alternatives and,
consequently, any method of determining costs and revenues for decisions which
attempts to deal with opportunities in isolation is unlikely to provide a complete
analysis. The main importance of the opportunity-cost concept is that
it forces the decision maker to consider all alternatives. This has important
information implications in that decision makers need to be aware of alternatives
and their consequences, and not just within their own area of responsibility.
Assuming this to be possible, OC does highlight the need for a comparison of all
alternatives. It is difficult to imagine, however, any sensible approach to decision
making that does not emphasize every close alternative as being a possibility.
 The use of opportunity cost is justified on the grounds that many
alternatives will be rejected outright without a formal analysis. It needs to be
realized, however, that although OC may occasionally offer such a short cut in
calculation; a corresponding danger is the potential not to consider the whole
problem. In other words, techniques which offer supposed short cuts may also have
the concomitant effect of not giving full consideration to the complexities of
possible cost behaviour and revenue patterns.
 The positive ‘profit’ implies that the alternative not only adds to a
company's net cash resources but is better than competing alternatives. Although
this information may, in some cases, be extra then needed it may, in others,
enhance the role of the accountant as a communicator of information for decisions.
Thus OC may be used as a behavioral tool to communicate the benefits of certain
courses of actions. However, given that OC must in part reflect the circumstances
consider by the decision maker and his/her attitude to risk, OC might just add
another dimension of complexity. Although all evaluation tools suffer at the hand of
an uncertain future, such problems may well be heightened in the case of OC. In
 other words, organizations may struggle to even recognize what constitutes a best
alternative, never mind quantify how much better it is than the next best
alternative.

Thus what is being argued is that although OC has a number of strengths, especially in
its emphasis on the need to consider alternative courses of action when making a
decision, it may have limitations from a practical business perspective. Furthermore,
even in those situations where OC could be calculated, it may well be extra then needed
in reaching a decision. To rank alternatives a business person would need to know the
OCs of the alternatives, but to know the OCs of the alternatives, he/she would first have
to know their values; thus to find the OC of alternatives there is a prior condition of
ranking them, hence making OC extra then needed to the decision process.

AN EXAMPLE OF THE USE OF OPPORTUNITY COST:

To illustrate some of the possible problems which may be associated with the
practical use of OC, however, we will use a decision context that is commonly used to
introduce the use of OC for decision making purposes namely, a special contract which
enables an organization to utilize some existing spare capacity, but which has resource
implications elsewhere in the organization.
A solution to Yellik Ltd using an OC approach is then derived, and its potential pitfalls
discussed, following which an alternative incremental cash flow approach is presented.

YELLIK Ltd.
Yellik Ltd has recently received a £90 000 contract proposal under which the
company would a unique component of Burley Brothers. Employing facilities which at
present are manufacture underutilized the special contract can be completed in six
months. The contracts office has put together estimates indicating that the contract
should not be accepted.

Yellik Ltd - contract estimates.

The following additional information is available:

1. Material A was bought for £20,000 two years ago for a similar contract
proposal that was not undertaken. As it stands, the material is of no immediate use
to Yellik Ltd and has zero re-sale value. Indeed, costs of £500 would have to be
 incurred in order to dispose of it. The stock of material A would be exhausted by
the current contract. Alternatively, it could be used in a few months time in
connection with a factory extension as substitute for certain pre-fabricated
supports which would cost £16,000. In this case, material A would first require
treatment and conversion at a cost of £2,000.
2. Material B is a very scarce resource which has therefore already been ordered
by the firm at a price of £15,000. Yellik Ltd is committed to paying this sum on
delivery. If, for any reason, Yellik Ltd cancels the order, then a 20% cancellation
charge will apply. If the company takes delivery, the material would have a re-sale
value of £11,600.
3. Direct labour will be sub-contracted to outside suppliers and paid on a piece-
work basis. It should therefore be treated as a variable cost.
4. The equipment which would be used for the proposed contract was purchased
a few years ago for £70,000. Its expected useful life was five years. At present it
could be sold for £20,000. In six months time its re-sale value is expected to
decline to around £15,000 if used on the contract.
5. The £8000 fixed overheads represent an allocation of general factory costs
that would remain unchanged whether or not the contract is undertaken. However,
if Yellik Ltd does not proceed with it, a part of the factory could be sub-let to a local
repair and maintenance business for £7,000 per quarter.
6. An administrator would be needed to co-ordinate the contract. Her salary is
£12,000 per annum. She could be seconded from her normal work as a
draughtsperson, her time lost on that work being made up by paying overtime
costing £3,000.

Yellik Ltd - solution using an opportunity cost approach

Yellik Ltd-solution using an incremental cash flow approach

 The opportunity cost approach to assessing relevant costs and benefits for the
decision at hand demonstrates (correctly) that the contract yields a net benefit of £5000.
The practical usefulness of this approach in business contexts, however, would
seem to be constrained by at least four limitations.

♦ The opportunity costs in the statement do not necessarily represent actual cash
flows. Where projects extend over more than one year (as is frequently the case),
it would normally be appropriate to employ some discounting technique to take
account of the time value of money. To do this it will be necessary to revert to a
separate analysis of annual cash flows.
♦ There were only two alternative overall courses of action in the Yellik Ltd
illustration; to go ahead with the contract, or not to go ahead with it.
♦ The opportunity cost approach only gives an answer in absolute terms, not in
relative terms.
 This can only be resolved by re-evaluating the contract in terms of
incremental cash flows for the two alternatives, that is, in terms of those cash
flows which change as a result of the action proposed.
♦ The benefit from accepting the contract is an increase in net cash flow of £5000
as before.

However, this seems less attractive than it did before since it only represents an 11%
increase on the amount that can be gained now as a result of not accepting the contract.
This may not be sufficient compensation for the extra uncertainty involved in
undertaking the contract.
Interestingly, the incremental cash flow approach not only resolves this fourth
limitation leveled at the opportunity cost approach, but it also answers the first three
criticisms discussed earlier.

DISCUSSION AND CONCLUSION:

The motivation for this article has been to examine some of the possible limitations
of using OC as a practical decision aid. Four separate issues have been raised and
illustrated through the example, Yellik Ltd.
1. The non-observability of OC was argued to make it difficult to control and monitor
decisions based on its use.
2. The notion of OC cannot allow for the timing of cash flows in situations where the
projects under consideration extend over more than one year, without reverting
to the separate consideration of individual cash flows.
 3. Where several alternatives are under scrutiny, the identification of the
appropriate base case might be non- trivial and thus create difficulties in the
calculation of OC.
4. OC leads to the evaluation of overall benefits that are difficult to assess in terms
of the original projects.

The above limitations and the example discussed in the text illustrate why the use of
an incremental cash flow approach to the analysis of business decisions might be
beneficial. It has the merits of clarity and simplicity, and is consistent with the
approaches normally adopted in other areas of management accounting such as
budgeting and investment appraisal.
The incremental cash flow framework could then be introduced as a technique which
resolves the key issues rose like difficulties in using Opportunity Cost approach.
The incremental cash flow approach has been found to be extremely helpful in
reducing the confusion that students often suffer when studying opportunity costs, and
so helps achieve the key learning objective that students are able to identify relevant
costs and benefits for decision making.