Question

In at least 200+ words respond to the following (please include any references)

Opportunity costs are very different from accounting costs as they are the cost of the next best decision. How do companies decide what the opportunity costs of a decision really are when the next best decision is often based on an estimate since the next best decision was not chosen?

Answer 1

The next best decision would be decided on the basis of the next best available alternative to the chosen alternative (assuming it's the best alternative). Suppose that you are planning to start a business involving the sales of furniture. You have to invest a certain amount of money to set up the shop i.e. payment of rent, purchase of furniture from the wholesale market, electricity, advertising etc. Now suppose you have saved $50,000 and are now planning to invest in setting up the furniture shop. The opportunity cost of this investment is the next best alternative in which you would prefer to invest the $ 50,000 that you possess. Taking into account your risk preferences, suppose the next best alternative is keeping the money as a fixed deposit in a bank and the bank interest rate is 10% pa. If the expected rate of profit per annum from investing in the business is greater than 10% pa, you would make the investment and your opportunity cost will be the 10% interest foregone. This has to be included while calculating the economic costs, but not the accounting cost. Companies also decide the opportunity cost of their investment on the basis of the expected returns foregone on the amount invested in any business venture as if it were invested in the next best investment alternative that the company prefers. Although the company did not invest in the next best alternative, it can gauge the expected returns on the investment using the current rates of return in that alternative investment and its variability over time.