Opportunity costs

Definition

Opportunity costs represent the potential benefits or profits an individual, investor, or business misses out on when choosing one alternative over another. It is a crucial concept in decision-making, helping to evaluate the relative profitability of different options.

5 Must Know Facts For Your Next Test

1. Opportunity costs are not recorded in financial statements but play a critical role in managerial decision-making.
2. They help managers assess the true cost of forgoing an alternative when making short-term decisions.
3. Understanding opportunity costs can lead to more informed and strategic choices by highlighting what is sacrificed when selecting one option over another.
4. In the context of short-term decision-making, opportunity costs often involve comparing potential revenues and costs of different projects or investments.
5. Ignoring opportunity costs can result in suboptimal resource allocation and missed opportunities for maximizing profitability.

Review Questions

• Why are opportunity costs important in managerial accounting?
• How do opportunity costs influence short-term decision-making?
• Can you provide an example where ignoring opportunity costs might lead to a poor business decision?

Related terms

Relevant Costs: Costs that will be directly affected by a specific management decision.

Sunk Costs: Past expenses that cannot be recovered and should not affect current decision-making.

Incremental Costs: Additional costs incurred if a particular action is taken.