The decision making Investment is a situation that investors face on a daily basis, when evaluating the different options, in order to choose the most convenient, the investor must know the opportunity cost of each of the options and be clear that when deciding on one of the options, the benefits of the other alternatives are abandoned.
In contrast, to the above, the benefits not perceived by discarding the next best alternative are the opportunity costs of the chosen action.
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In this article you will find:
What is an opportunity cost?
It is a deferred consequence of the choice of an investment, between two or more alternatives, this means that depending on the chosen alternative, if it does not provide the expected benefit, it generates a cost of chance.
Despite the opportunity costs They are not recorded in accounting, but must be considered relevant since they contribute to decision-making and their corresponding consequences for the company or the investor.
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In simple words, some definitions of opportunity cost are:
- It is the value immolated when making an investment or economic decision.
- It is the amount that is missed when choosing another available alternative.
- It is the renunciation of an income that could be obtained by opting for the option with greater advantages instead of the one that has been chosen.
- It is the lost profit of the superior lost opportunity.
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Accounting costs versus opportunity cost
There is a very clear difference between what the costs are from the accounting point of view and the Opportunity cost, in terms General, when costs are mentioned, reference is made to the expenses incurred for the productivity of the company, while the opportunity cost is not accounted for and occurs when a profit is abandoned, as a result of decision-making between several options.
Conditions that generate the cost or opportunity cost
- Choice between two or more investment alternatives.
- An income that could be obtained when the most beneficial option was chosen instead of the one that had been chosen is no longer received.
- Cost of producing goods measured by the magnitude of the option not chosen.
- Since everything has a cost, the absence of the benefit is reflected in the lost opportunity.
Opportunity cost approaches
Within the scope of Cost Accounting.
The decision to use a resource exclusively may cause an investor to discard the opportunity to use other resources proposed in other options. The loss of this opportunity generates a cost for the administrator who must consider the chosen decision.
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In this sense, this opportunity cost is the contribution to the operating profit from which the investor has disposed of.
Within the scope of financial evaluation in investment projects
In this approach, reference has been made to the attractive Minimum Return Rate known as TREMA.
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This interest rate is considered the lowest acceptable rate of return that any business must contribute during the decision process. In addition, it serves as a benchmark for comparison with Internal Rate of Return (IRR) in order to measure the return on investment.
It is known that the TREMA oscillates according to the area in which the project is developed, it may well be in the area of health, education, agriculture, among others. Becoming one of the strategies most used by companies to select their future investments and thus define the financial strategy.
It is worth noting that the possible inflation during the project development time. Regarding the opportunity cost, reveals the risk of carrying out a project, related to the probability of obtaining the expected income from it, then it turns out that if the probability of profit is very high, it implies a minimum risk and obviously if the opposite is the case, the investment risk is high.
Within the scope of evaluation of social projects
From this point of view, the discount rate applied to the opportunity cost is the interest applied to investments to offset them with other businesses or other investments. In this approach, the investments will reflect the social condition of the project over time.
The discount rate has a minimal impact when the investment is short-term. This rate, related to the evaluation of private projects, is similar to the evaluation of a social project. Logically the use of the availability of resources in one investment excludes the use of resources in another.
By equity criteria, the greater the redistribution that is generated, the lower the discount rate should be. When the equity criterion is applied in the investment project, the discount rate is lower.
