Terms Beginning With 'o'

Opportunity cost

  • October 19, 2020
  • Team Kalkine

Opportunity cost is a tool or a method to determine the true and full value of any activity by taking into account the value of the next best alternative available. It helps in conducting cost-benefit analysis and integrates the cost-effectiveness and value considerations.

For instance, if I have $20 with myself. I could use it to buy a burger, and a drink for my lunch or I could have settled for a decent buffet where I could enjoy more varieties of food. Since the resource ($20) is limited, one has to consider the choices of using that resource best suited for oneself.

The concept of Opportunity Cost is widely used in the field of economics since the resources are limited or scarce while needs are limitless. The opportunity cost does not appear in any accounting books or financial report of any company. But the businesses try to evaluate their time and money invested in a venture with respect to best available alternative or forgone opportunity to check their decision making effectiveness.

Suppose a business house plans to invest $1 million in a new project which will start giving returns after 5 years. Now there are many factors which will come into play while determining the opportunity cost of the project. The true value of money will enter into the dynamics as the profit or loss will happen in more than 5 years. Let us analyse the economics of the project in the purview of opportunity cost.

  • Capital Investment

The business house may invest $1 million entirely from its reserves or could arrange for long term debt. Now the debt could be 100% for the project cost or may cover a part of it. For the sake of simplicity in the calculation, let us assume the firm gets 80% debt and rest 20% from its own reserves. Let us also assume that the rate of interest is 5% per annum.

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  • Project becomes operational

Now suppose that the project takes 1 year to become operational. The interest on the debt would come up to $40,000 @5% in one year. After one year, the project’s total capital cost would now be $1.04 million and plus the firm would have earned on the $200,000 through bank deposit interests or through investment in share market. In this case, the opportunity cost after one year would be the loss of interest/ return on investments for $200,000.

 

  • The 3rd stage

The company starts generating revenue and starts paying for its operations and bank debt. There are two case scenarios from here. First, the company starts making good profits and soon reaches its breakeven point, and the project becomes profitable. Second, the business model flops and starts incurring losses on its operations.

In either case, the opportunity cost should be analysed with respect to another alternative that the company could have done with the resources it had. Well, running a firm or a business is not that easy and determining the outcomes based on simple assumptions would not work here. For actual results, actual data would have been required.

So a simple formula can be deduced from the above discussions for the opportunity cost.

A negative value of opportunity cost means the most appropriate decision has been made. One important aspect needs to be kept in mind always while determining the opportunity cost. The selection of the forgone option or the alternative is also of vital importance.

The best way to assess the options for determining the opportunity cost is to look for the alternatives that can yield the highest returns. The company, in the above example, could have invested its own capital in the stock market and could earn some returns without paying any interest or investing time in a new project. Alternatively, investment in the stock market comes with some degree of risk. The company would have earned more from the project.

There will be some opportunity cost involved whatever decision is made and is unavoidable. 

Types of Opportunity Cost

Opportunity cost does not need to always involve monetary value. Sometimes, time or degree of satisfaction is also involved when the monetary factor is constant on all options involved. So opportunity cost can be classified into two categories:

  1. Explicit cost

The above discussed two examples are classic cases of explicit opportunity cost, where some sort of monetary value is involved. In both cases, the transaction of money is involved, and the opportunity cost for the foregone option will involve some monetary value.

 

  1. Implicit cost

No monetary transaction is involved. Factors like time or degree of satisfaction come into play here. Suppose I want to go for a walk during my free time. Now there is “n” number of possibilities to utilize that free time. May be one could have sat over a couch and watched a television or could enjoy some videogames. One could have read some interesting books while staying in the house. So the opportunity costs in these cases are intrinsic in nature and cannot be measured on monetary terms.                         

The crux of the entire discussion is that every activity, whether explicit or implicit costs, involves some opportunity cost. It is something which is unavoidable but comes in to play once the activity is completed.

What is an Absolute Advantage? Absolute advantage is one of the key macroeconomic terms, which is based on the principles of Capitalism and is often utilised in international trade-related decisions. Absolute advantage refers to the competence of a company, region or country to produce goods or services in an efficient manner compared to any other economic entity. The efficiency in production can be achieved by: Production of the same quantity of good or services as produced by other entity by utilising fewer amount of resources Production of a higher quantity of good or services as produced by other entity by using the same amount of resources What is the Significance of Absolute Advantage? Different countries or businesses possess a different set of ability owing to their location, soil composition, weather, infrastructure, or human resource skills. When applied in the right direction, various factors may pan out to offer more cost-effectiveness and hence build absolute advantage of the entity in comparison to others.  The absolute advantage remains one of the critical determinants for the choice of the goods or services to be produced. Absolute advantage in a particular area often translates into profitability in the area. The profit margin increases by the achievement of cost efficiency, allowing the entity to ensure higher profitability over the competitors.  For example, let us assume that the US can produce ten high-quality aircrafts utilising a specific amount of resources. China, on the other hand, can build 6 similar quality aircrafts using the same amount of resources. Thus, in the production of an aircraft, the US holds Absolute Advantage Let’s say the US has the ability to manufacture a certain amount of steel using 10 tonnes of iron ore. China, on the other hand, can produce the same quantity of steel using 8 tonnes of iron ore.Here, China here holds Absolute Advantage in the production of steel.  How Countries Build Absolute Advantage? While natural conditions, which include climatic factors, geometry, topography, cannot be altered for achieving absolute advantage, the countries use the underlying factors strategically in their favour. Furthermore, factors of production are focused at by many companies or nations for building absolute advantages.  Some of the strategies for building absolute advantage includes: Development of Technological Competencies- The implementation of innovative or latest technological innovations allows the entities to lower their production cost, facilitating absolute advantage.  Enhancing Skills of Human Resources- The improvement in the cost-efficiency, along with the quality of the products, is targeted through imparting varying skill development programs. Many countries subsidize or aid the apprentice or labour training for enhancing the absolute advantage in trade.  Improving Infrastructure- The infrastructure enhancement in the form of road, telecommunications, ports, etc. can be useful in enhancing the cost-effectiveness across different industries.  What Do We Understand by Comparative Advantage Vs Absolute Advantage? Evaluating the comparative advantage introduces the concept of opportunity cost, which is the deciding factor to determine the production of particular goods or services. Opportunity cost refers to the potential benefits associated with the next best possible alternative which is missed out when one option is chosen over another.  The Absolute advantage simply considers the capability of a business or region to deliver goods or services in the most efficient manner. The Comparative Advantage, however, also takes into account the benefits that are forgone if an entity decides for production of a particular product or services.  Comparative advantage, based on the notion of mutual benefits, is often used in international trade deals. The Comparative advantage has been the major factor driving the outsourcing of services in search of cheap labour.  Understanding through an Example For instance, country A can produce ten televisions with the same amount of resources with which it can make 7 laptops. The opportunity cost per television is 7/10 or 0.7 laptops. Meanwhile, the opportunity cost per laptop is 10/7 or 1.42 television.  It highlights that country A is forsaking the production of 0.7 laptops if it is deciding to manufacture one television. On the other hand, it is missing out the opportunity to manufacture 1.42 televisions for every single laptop manufactured.  Now, say Country B’s opportunity cost for producing a television is 0.5 laptop, and that of producing laptop is 2 televisions. Then, country B will have a comparative advantage in making televisions, and country A will have comparative advantage in producing laptops. It has to be noted that despite country A having absolute advantages in both the products, it would be mutually beneficial for both the countries if country B produces television while country A produces laptops. Do You Know About Absolute Advantage Theory by Adam Smith? The concept of Absolute Advantage was indicated by Adam Smith in his book called ‘Wealth of Nations’ which focusses on International trade theory. Adam Smith, in his book attacked on the previous mercantilism theory, which mainly stressed for economies to maintain trade surplus in order to command power.  The Absolute Advantage theory considered that the countries possess different ability with respect to the production of varying goods or services. It argued that it is not necessary that a state may hold an absolute advantage in the production of all goods, and here the relevance of trade comes into play.  It advocates that countries should produce those goods over which they hold a competitive advantage. It would allow the countries to make the same amount of goods using few resources or in less time. The theory propagates the relevance of trade for economic sustainability.  What Are the Limitations of the Absolute Advantage Theory? The assumptions used in the Absolute Advantage Theory by Adam Smith may limit the application in real bilateral trade. The limitations of the theory by Adam Smith include: Smith assumed that the productive capabilities of a country could not be transferred between the two countries. However, in practical terms, the competitive scenario aids the nations to acquire new capabilities and acquire new resources, especially in the technological and human resource skill aspects.  The two-country trade which was used as a basis for the theory does not consider the trade barriers levied. The present scenario, however, is strikingly dominated by trade wars between economies. Nations impose huge tariffs, import duties and other type of barriers to promote local manufacturers.  Absolute Advantage theory assumes that the trade between the two nations will take place only if each of the two economies holds an absolute advantage in one of the commodities traded. However, in general, countries despite not holding absolute advantage are engrossed in international trade, boosting their economic setup.

Calculating the cost of a product or an enterprise based on the direct and the indirect costs (overheads) involved. Multiple methods of absorption costing include Direct labour cost percentage rate, Direct material cost percentage rate, Labour hour rate , Prime cost percentage rate and Machine hour rate.    

What are accounts payable? Accounts payable is the amount of cash a company is liable to pay to its suppliers and clear dues. As current liabilities of the company, accounts payable is required to be settled over the next twelve months.  It also shows the obligations of the business over the next year. Accounts payable is required to be repaid in a short period, depending on the relationship with suppliers. It is essentially a kind of short term debt, which is necessary to honour to prevent default.  As a part of the company’s working capital, it is widely used in analysing the cash flow of the business and cash flow trends over a period. Accounts payable may also depict the bargaining power of the company with its vendor and suppliers.  A vendor or supplier may give the customer longer credit period to settle the cash compared to other customers. The customer here is the company, which will incur accounts payable after buying goods on credit from the vendor.  There could be many reasons why the vendor is providing a more extended credit period to the firm such as long term relationship, bargaining power of the firm, strategic needs of the vendor, the scale of goods or services.  By maintaining a more extended repayment period to supplier and shorter cash realisation period from the customer, the company would be able to improve the working capital cycle and need funds to support the business-as-usual.  However, prudent working capital management calls for not overtly stretching the payable days as it might lead to dissatisfaction of supplier. Also, investors tend to closely watch the payable days cycle to determine the financial health of the business. When the financial conditions of a firm deteriorate, the management tend to delay the payment to their suppliers. What is accounts payable turnover ratio? Accounts payable turnover ratio shows the capability of a firm to pay cash to its customer after credit purchases. It is counted as an essential ratio to analyse the cash management attribute of the firm and its relationship with vendors or suppliers.  It is calculated by dividing purchases by average accounts payable.  Purchases by the company are calculated as the sum of the cost of sales and net inventory in a given period:  Now let’s understand this the help of an example. Let us suppose, Cost of sales of Company XYZ for the period was $60,000, and XYZ began with inventories worth $21000 and ended at $15000. Accounts payable at the beginning was $20000, and $15000 at the end.  Now the purchases will be $66000 (60000+21000-15000). The average accounts payable will be $17500. Therefore, the accounts payable turnover ratio will be 3.77x.  Dividing the number of weeks in a year by the accounts payable turnover ratio will give the number of weeks the company takes on average to settle its payables. In this case, it will be around 13.8 weeks (52/3.77). 

An alternative to traditional stock exchanges, dark pools are referred to private forums or exchanges formed for trading of securities. They offer an opportunity to investors to make trades without revealing their intentions publicly.

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