The Cost of Bad Decisions

Opportunity costs are the cost (financial, time, resource, other) of forgone opportunities.  They are the things you can’t do, or what you’ve given up, when deciding between two or more options. Understanding the opportunity costs of decisions are particularly important when resources are scarce it ensures that scarce resources are used efficiently and in the best interest of the company.  For example, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose the asset could have been used for.

Most opportunities are difficult to compare. Opportunity cost has been seen as the foundation of the marginal theory of value as well as the theory of time and money. In some cases, it may be possible to have more of everything by making different choices.  In microeconomic models this is unusual, because individuals are assumed to maximize utility, but it is a feature of Keynesian macroeconomics when one investment is assumed to be as good as any other.

Opportunity cost analysis should be an important part of a company’s decision-making process, but it’s not treated as an actual cost in any financial statement. However, opportunity costs can impact every financial aspect measured.  For example, a business may pay a month rent all year for rent on a warehouse that it only uses six months out of each year. If the business could rent the warehouse out for the unused six months it could increase other income or reduce costs. Either way the difference will fall to the bottom line.

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