How to calculate opportunity cost?

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How to calculate opportunity cost

How to calculate opportunity cost. Opportunity costs are complex. This is an advantage that is not realized. That can be the profit that is foregone because the machine for making products is not bought. When making financing decisions, the opportunity costs often consist of lost interest in the investment opportunity. However, it is also possible to calculate cost advantages that have not to achieve.

Approach via contribution margins

The approach of lost profit margins as opportunity costs is widespread. In a bottleneck (e.g. a packaging machine), the decision to manufacture a product displaces other products that would have generated a contribution margin for the company. This must be less than the contribution margin generated by the product that is now being manufactured. This should have resulted from the calculation of the advantages of different program variants. The analysis of the opportunity costs shows how much the decision for the chosen alternative costs.

In the case of imputed costs that evaluate an alternative use of production factors, the opportunity costs calculates as lost income or revenue for alternative use. The amount of these costs depends heavily on the assessment of the cost calculator. How high are the interest rates that can achieve on the market? What is a fair entrepreneur’s wage?

Opportunity costs in the profitability calculation

In the profitability calculation, the advantageousness of behavioural alternatives determine. Regardless of whether it is a question of investment decisions or other content, the result of each choice always determines at the end of the calculation. With just a few exceptions, the possibilities with adverse effects can rule out immediately. All positive alternatives will implement as long as the appropriate funds (capital, capacities, etc.) are still available. In the case of divisible options, this procedure leads to the result relatively quickly. However, it becomes problematic when the options can only implement in whole or not at all.

In such cases, considering opportunity costs can be one way of determining the decision.

Practical example: How to calculate opportunity cost

Opportunity costs in the profitability calculation

The decision between two machines is shown as an example. Only one of the investments can realize because the space in the production halls limits. Machine A costs 500,000 EUR, and an annual result of 50,000 EUR can expect. Machine B costs EUR 300,000 and makes a profit of EUR 45,000 per year. The decision would have to make in favour of machine A, producing a higher yield. However, for each of the alternatives, there is the option of investing the capital with the bank and thus earning 8% interest annually. These must take into account as opportunity costs.

Explain and confirm results through opportunity costs

It turns out that opportunity cost is just one way to demonstrate the benefits of multiple alternatives. Whatever method you choose is up to you. Practice often uses opportunity cost to confirm and explain results.

Opportunity costs and imputed costs: How to calculate opportunity cost

The imputed costs in the context of full cost accounting have the character of opportunity costs. They use cost accounting to create comparability between different companies or sub-areas and evaluate further use of factors—the imputed interest rate z. B. apply to equate existing equity with debt. Taking this imputed type of cost into account means that the charging of cost centres and cost units with interest is independent of the company’s financial structure.

This also applies to the imputed entrepreneur’s wages. Here, too, the alternative use of the factors, in this case, the workforce of the entrepreneur,  assess. The products must bear these opportunity costs in their calculation. The imputed rent partially replaces the other building costs, such as B. Depreciation. It also includes notional profits that a landlord would make
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