Opportunity Cost

Would you please help me understand opportunity cost?

source: http://blog.accountingcoach.com/opportunity-cost/

You might think of opportunity cost as the profit you had to forego.

Let’s illustrate this with a little story. Suppose that you are the sole owner of a company which uses a special machine to produce a very unique product. Your company has a huge backlog of orders for the product. Every hour that the machine is running, your company is able to generate sales of $500 while incurring incremental costs and expenses of $200. As a result, your company’s profit is increasing by $300 for each hour that the machine is running.

Now suppose an employee failed to perform a routine maintenance task which causes the machine to be shut down for 10 hours. The repair bill to get the machine running was $400. What was the cost of the machine being down for 10 hours? The accounting records will report $400 in the account Repairs and Maintenance Expense. But as the owner, you are likely to be more upset that the employee costyou $3,000 (10 hours X $300) in lost profits and upset customers.

In the above story the opportunity cost was $3,000 of lost profit + the cost of the upset customers. (From the owner’s perspective, the total cost was the $400 repair bill + $3,000 of opportunity cost described above + the opportunity cost consisting of future lost profits from lost customers.)

Now let’s modify the story. Suppose the machine that was idled by employee negligence was not a special machine and there was no backlog of orders for the product. The repair bill was the same $400. In this situation you will not be foregoing any sales or losing any customers. Therefore the profitforegone is $0. In other words, there is no opportunity cost of the machine being down for 10 hours. All you have is the $400 repair bill.

This concept of opportunity cost is relevant in making decisions. For example, in deciding whether to make or to buy a component, the opportunity cost is an important consideration: If your plant has idle capacity, you might opt to make a component because there is no opportunity cost—no profit being foregone as you spend time making the component. On the other hand, if your plant is operating at full capacity, you would have to forego the profit on some items presently being produced (an opportunity cost) in order to make the components.

The concept of opportunity cost is also relevant when setting transfer prices between divisions or subsidiaries of a large company.

Definition of 'Opportunity Cost'

1. The cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.2. The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment - say, a risk-free government bond y 6%. In this situation, your opportunity costs are 4% (6% - 2%).

Investopedia explains 'Opportunity Cost'

1. The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages.

Here's another example: if a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.).

In both cases, a choice between two options must be made. It would be an easy decision if you knew the end outcome; however, the risk that you could achieve greater "benefits" (be they monetary or otherwise) with another option is the opportunity cost.

source:http://www.investopedia.com/terms/o/opportunitycost.asp#ixzz25Y76QNJN

The opportunity cost of deciding not to work is the lost wages foregone 

The opportunity cost of spending money on a foreign holiday is the lost opportunity to buy a new dishwasher or the chance to enjoy two short breaks inside the United Kingdom

The opportunity cost of the government spending £20 billion on interest payments on the national debt is the extra money it might have allocated to the National Health Service

The opportunity cost of an economy investing its resources in new capital goods is the current production of consumer goods that is given up 

The opportunity cost of using arable farm land to produce wheat is that the land cannot be used in that production period to harvest potatoes

source: http://tutor2u.net/economics/content/topics/introduction/opportunity_cost.htm