Business establishments, especially manufacturing and service industries, utilize and apply resources to produce marketable goods and services. In doing so, several costs are incurred that may be notional and actual costs or implicit and explicit costs. As the intention of business activity is to earn real profits, it is essential that all costs involved are determined and taken into consideration. This serves several purposes such as decision making, pricing, cost control and management etc. The first step to calculate costs is to categorize the various types of costs that may be incurred while carrying out business activities. This article looks at meaning of and differences between two cost categories – opportunity cost and money cost.
Definitions and meanings
Opportunity cost is the measure of profit foregone when choosing one business alternative over the other. Resources are typically scarce yet they have multiple uses. In a business, management must evaluate and choose amongst various options of resource utilization. To correctly make this choice, the costs and benefit of each alternative must be calculated. When a final decision is taken, the profit that could have been earned but is foregone, when selecting one alternative over another, represents the opportunity cost of the final selection made.
Example of opportunity cost
ABC Inc. has an additional unused manufacturing machine. It has two options:
- Renting out this machine to external job workers for a fixed monthly rent of $10,000.
- Introducing this machinery into its production line to increase its production capacity.
While evaluating these decisions, ABC Inc. has to calculate the incremental profit that its own business can generate by employing this machine. The opportunity cost of doing so is the rent of $10,000 monthly that it would have to forego. Ideally, ABC Inc. should employ the machine in its own business if doing so can generate an incremental profit of at least $10,000 per month.
By nature, opportunity cost is a notional cost which does not involve any cash outflow and not an actual cost that normally involves a cash outflow.
Money cost is the actual cash cost incurred in the production and sale of marketable goods or services. Money cost is a summation of several costs that result in a cash outflow for the business. These generally include:
- Direct material cost – raw materials, packing materials
- Direct labor costs – factory workers salary
- Direct overheads – factory rent, plant depreciation
- Indirect material and labor costs – stationery, office staff salary
- Indirect overheads – advertising and marketing, distribution costs, administrative costs, legal costs
Any costs that require monetary settlement would qualify as a money cost. These may be incurred in cash or on credit to be settled later.
Examples of money cost
For an entity, the entire range of actual costs from the price of raw material purchased for production to legal costs incurred for registering its patents, everything that has to be paid for is referred to as money cost.
Difference between opportunity cost and money cost
The eight key points of difference between opportunity cost and money cost are as follows:
- Opportunity cost represents the quantum of profit that is let go, when an entity chooses one resource utilization alternative over another.
- Money costs are the actual cash (or credit) costs that an entity incurs during its business operations.
2. Nature of cost
- Opportunity cost is a notional cost as it is in the nature of loss of potential profit and not actual cash cost incurred.
- Money cost is an actual cost that is incurred and requires actual settlement through payment via cash, check or draft etc.
3. Cash outflow
- Opportunity cost does not result in any direct cash flow for the entity.
- Money cost results in direct cash outflow either immediately or in future.
4. Accounting and financial reporting
- Opportunity costs being notional are not accounted for in formal accounting records. They may, however, be reported in internal management reports.
- Money costs are actually incurred and thus accounted for as well as reported in financial statements.
5. Timing of calculation
- Opportunity cost is typically calculated during the decision-making process i.e., before any decision on resource utilization is taken.
- Money costs are incurred and calculated on an ongoing business so long as the business operations are in process.
6. Calculation accuracy
- Opportunity cost is often an estimation as it requires an estimation of potential profit that may be earned from a particular alternative. It thus may suffer from some inaccuracy.
- Money cost tends to be more accurate as it is often a historical cost i.e., calculation of costs actually incurred.
7. Trigger of cost
- The trigger for opportunity costs to arise is the fact that resources are generally scarce but can be applied for multiple uses. The management is concerned with the selection of the best or optimal application of the available resources.
- The trigger for incurring money costs is the actual application of resources for production, marketing and sale of goods and services with a view to earn profits.
8. When the cost is nil
- Opportunity costs will be nil when there is no alternative use for a resource.
- Money costs can be nil when there is no business activity. Even then, fixed costs may still be incurred.
Conclusion – opportunity cost vs money cost
Both opportunity and money costs are important for efficient management of business activities. While the calculation of opportunity costs is important for decision making as well as evaluation of management decisions, the calculation of money costs additionally has several purposes such as setting prices, assessing profitability, cost control, cost management, financial reporting etc. They both have an impact on potential profitability and thus must be calculated appropriately.