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Chapter 6

Opportunity costs

Opportunity cost is the value of the best alternative that is foregone
when a particular course of action is undertaken. It emphasises that
decisions are concerned with choices and that by choosing one plan,
there may well be sacrifices elsewhere in the business.

Example 2

A new project requires the use of an existing machine that would otherwise be
sold. Information concerning the machine is as follows:

 Original purchase price = $20,000

 Current net book value(NBV) = $5,000

 Estimated current sales value = $4,000

What is the relevant cost (if any) of using the machine in the project?

The original purchase price is sunk so not relevant.

The NBV is a combination of the purchase price (sunk) and depreciation (not a
cash flow) so is not relevant.

By undertaking the project we miss out on the opportunity of selling the asset
and thus have an opportunity cost of ($4,000).

Cash position if accept proposal NIL

Cash position if reject proposal (and do best alternative instead): receive
$4,000.

So relevant cash flow = $4,000.

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