How to Weigh Opportunity Costs in Cost Accounting
In cost accounting, opportunity cost is what you give up by making a decision to go in one direction rather than another. Opportunity costs occur because all businesses have limited resources.
For example, you only have so many machine hours you can use to produce goods. At some point, you have to decide how to use those hours to maximize profit. When you decide to concentrate on one product, you give up the chance to concentrate on another one, and that’s an opportunity cost.
Here’s an example of opportunity costs in a decision to outsource. Say you’re losing money on a product, so you consider outsourcing it. On the left, you have the results of closing a company division. On the right, you see where you stand after the division is closed.
|Before Closing||After Closing|
|Less variable cost||-$550,000||$550,000|
|Equals contribution margin||$450,000||-$450,000|
|Less fixed cost||-$480,000||$370,000|
The After Closing column is a little tricky. Here’s an explanation: When you close the division, you lose $1,000,000 in sales (a negative). You also gain (by not spending) $550,000 in variable costs. The net result is that your contribution margin goes down by $450,000.
You also save the money you were spending on fixed costs; however, only $370,000 is added back in the right column. Not all of your fixed costs are eliminated. It makes sense, as many fixed costs (such as the building lease) are set up by contract. As long as the contract is in force, the company incurs the cost.
In this example, you’re worse off if you close the division. In fact, you lose $50,000 more than if you keep the division open (losing $80,000 versus losing $30,000).
The information in the table suggests what to do: Keep operating until those fixed costs can be covered by another division or until the commitment to pay those costs ends. If the loss from the division staying open ($30,000) is less than the loss from the division closing ($80,000), keep operating. And who knows? You might be able to turn things around and make the division profitable.