The Opportunity-Cost Approach

Deciding to use a resource one way means a manager must forgo the opportunity to use the resource in any other way. This lost opportunity is a cost that the manager must consider when making a decision. Opportunity cost is the contribution to operating income that is forgone by not using a limited resource in its next-best alternative use. For example, the (relevant) cost of going to school for a bachelor’s degree in accounting is not only the cost of tuition, books, lodging, and food, but also the income sacrificed (opportunity cost) by not working. Presumably, however, the estimated future benefits of obtaining an accounting degree (such as a higher-paying career) will exceed these out-of-pocket and opportunity costs.

Exhibit 12-7, Panel B, displays the opportunity-cost approach for analyzing the alternatives Soho faces. Note that the alternatives are defined differently under the two approaches:

The opportunity-cost approach does not reference Digiteks. Under the opportunity-cost approach, the cost of each alternative includes (1) the incremental costs and (2) the opportunity cost, the profit forgone from not making Digiteks. This opportunity cost arises because Digiteks is excluded from formal consideration in the alternatives.

Consider alternative 1, making DVD players for its 2-in-1 system. What are all the costs of making DVD players for its 2-in-1 system? Certainly Soho will incur $15,000,000 of incremental costs to make DVD players for its 2-in-1 system, but is this the entire cost? No, because by deciding to use limited manufacturing resources to make DVD players for its 2-in-1 system, Soho will give up the opportunity to earn $2,500,000 by not using these resources to make Digiteks. Therefore, the relevant costs of making DVD players for its 2-in-1 system are the incremental costs of $15,000,000 plus the opportunity cost of $2,500,000.

Next, consider alternative 2, buying DVD players for its 2-in-1 system. The incremental cost of buying DVD players for its 2-in-1 system is $16,000,000. The opportunity cost is zero. Why? Because by choosing this alternative, Soho will not forgo the profit it can earn from making and selling Digiteks.

Panel B leads managers to the same conclusion as Panel A: buying DVD players for its 2-in-1 system and making Digiteks is the preferred alternative.

Panels A and B in Exhibit 12-7 describe two consistent approaches to decision making with capacity constraints. The total-alternatives approach in Panel A includes all future incremental costs and revenues. For example, under alternative 2, the additional future operating income from using capacity to make and sell Digiteks ($2,500,000) is subtracted from the future incremental cost of buying DVD players for its 2-in-1 system ($16,000,000). The opportunity-cost analysis in Panel B takes the opposite approach. It focuses only on DVD players for its 2-in-1 system. Whenever capacity is not going to be used to make and sell Digiteks, the future forgone operating income is added as an opportunity cost of making DVD players for its 2-in-1 system, as in alternative 1. (Note that when Digiteks are made, as in alternative 2, there is no “opportunity cost of not making Digiteks.”) Therefore, whereas Panel A subtracts $2,500,000 under alternative 2, Panel B adds $2,500,000 under alternative 1. Panel B highlights the idea that when capacity is constrained, the relevant revenues and costs of any alternative equal (1) the incremental future revenues and costs plus (2) the opportunity cost. However, when managers are considering more than two alternatives simultaneously, it is generally easier to use the total-alternatives approach.

Opportunity costs are not recorded in financial accounting systems. Why? Because historical recordkeeping is limited to transactions involving alternatives that managers actually select rather than alternatives that they reject. Rejected alternatives do not produce transactions and are not recorded. If Soho makes DVD players for its 2-in-1 system, it will not make Digiteks, and it will not record any accounting entries for Digiteks. Yet the opportunity cost of making DVD players for its 2-in-1 system, which equals the operating income that Soho forgoes by not making Digiteks, is a crucial input into the make-or-buy decision. Consider again Exhibit 12-7, Panel B. On the basis of only the incremental costs that are systematically recorded in accounting systems, it is less costly for Soho to make rather than buy DVD players for its 2-in-1 system. Recognizing the unrecorded opportunity cost of $2,500,000 leads to a different conclusion: buying DVD players for its 2-in-1 system is preferable to making them.

Suppose Soho has sufficient capacity to make Digiteks even if it makes DVD players for its 2-in-1 system. In this case, the opportunity cost of making DVD players for its 2-in-1 system is $0 because Soho does not give up the $2,500,000 operating income from making and selling Digiteks even if it chooses to make DVD players for its 2-in-1 system. The relevant costs are $15,000,000 (incremental costs of $15,000,000 plus opportunity cost of $0). Under these conditions, Soho’s managers would prefer to make DVD players for its 2-in-1 system, rather than buy them, and also make Digiteks.

Besides quantitative considerations, managers also consider strategic and qualitative factors in make-or-buy decisions. In deciding to buy DVD players for its 2-in-1 system from an outside supplier, Soho’s managers consider factors such as the supplier’s reputation for quality and timely delivery. They also consider the strategic consequences of selling Digiteks. For example, will selling Digiteks take Soho’s focus away from its 2-in-1 system?