Opportunity Cost can help you to rationalize your cost management decisions!

Economics starts from the concept the scarcity of resources. All of its branches including managerial economics develop models to help in the allocation of resources on economic rationales. Being a manager, you can have a number of needs and plans for your business, but you can’t afford to allocate your resources to all of those opportunities. Consequently, you have forced to shortlist your choices. You should keep an eye on your short list of data and arguments and go for the best one.

What about the opportunity next to the best one?

Suppose you allocate your resources to the next best opportunity what would be your gains? Whatever value is calculated, it is the opportunity cost.

The New Oxford American Dictionary defines it as "the loss of potential gain from other alternatives when one alternative is chosen."

Forbes defines it as:

“Opportunity cost is the risk of making decisions now that result in lower returns over the longer term than you would have gotten otherwise.”

The economists like to define it as:

“It is the value of the next best-foregone opportunity.”

Real Life Examples of Opportunity Cost

I have been working with the government as a full-time employee. In those days I was asked by the Red Crescent to manage its local charity hospital to improve its financial health and quality of services in part-time. Having an experience of work at the Public Health of Singapore, it was an exciting offer. I had also a chance to exercise my ideas and studies into public as well as private institutions simultaneously.

We introduced biometrics to ensure attendance of the staff. We placed closed-circuit TV cameras to have a blanket monitoring. We also brought in patient flow management system to manage the patients in an organized manner.

These steps and physical improvement of the infrastructure increased our OPD as well as indoor patients by 30% within three months. It became a problem for our doctors in two shifts to handle all patients efficiently. We immediately needed two gynecologists and a couple of staff nurses. We also needed a new ultrasound machine to diagnose the patients quickly.

Our resources were allowing us to go for one option during the current month by keeping in view our financial resources:

1-   Purchase a new ultrasound machine

2-   Hire two new gynecologists and staff nurses

If we could go for the first option, we could diagnose the patients with better equipment. It could add up to the quality of our services besides increasing survival rate of the neonatal. But it was not going to help us to retain the untreated patients.

However, if we would select the second option, we could handle more patients and increase our revenues. It could also add up to our capacity to control the number of patients.

By analyzing all pros and cons and keeping in view the primary mission of our hospital, we decided to go for the first option. The executive board thought that improvement in the quality of services was one of the objectives to induct a professional manager in the system.

The opportunity cost was a loss of revenue which we could have generated by hiring new doctors. We could calculate the loss in monetary terms very quickly. However, we decided to forgo that for improvement in health services. We also decided to hire new staff as soon as possible to recover the value.

If we would have decided to go for the hiring of new staff our cost of opportunity could not be calculated in monetary terms. We would have to measure it regarding patient satisfaction, quality life, saved lives of infants and mothers, etc.

Furthermore, the value can’t always be a digital number. It is the value of the alternative that we have forgone for our selected choice.

Our real-life example discusses only two alternatives. In fact, we had other options as well including construction of a new operation theater, improvement of the existing operation theater, beautification of the hospital environment, etc. But for opportunity cost, we can go for only the next best alternative to our decision. We can evaluate the value by analyzing cost-effectiveness or cost-utility.

It is essential to keep in mind:

1-   The opportunity cost is always a value

2-   It is the value of the forgone opportunity

3-   We have to select the best opportunity

4-   It is valuable but not available in the accounting books

5-   You have to use your brain and data available to select a better alternative

6-   You have to recover the opportunity cost as soon as possible

Cost Management

Types of Opportunity Cost

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