*The game referenced in this article is ‘The Tribez‘ offered by Game Insight UAB.
We spoke previously about the Opportunity Costs associated with Trade-offs.
Trade-Offs → the situation where both benefits and costs result from choices between two or more alternatives.
Opportunity A (Lengthy Deal)
- Benefits (Pros)
- 1.94 Food per stone
- Costs (Cons)
- 2.77 Rocks per Stone
- 1.33 Hours of Energy per Stone
Opportunity B (Standard Deal)
- Benefits (Pros)
- 2.40 Rocks per Stone
- 1.2 Hours of Energy per Stone
- Costs (Cons)
- 2 Food per Stone
This farmer faces a trade-off regardless of whether they choose the lengthy or standard deal.
Opportunity A is cheaper in terms of food but more expensive in terms of rocks and hours. Opportunity B is cheaper in terms of rocks and hours, but more expensive in terms of food.
Almost all resources have more than one possible use (wood can make firewood or lumber for housing; labor can produce music or kites; time can be used for studying or reading). When the resources is used on one way, all alternative uses are then sacrificed. Wood cannot both be burnt in a fire for heat and be used in lumber for house-building. You cannot use your energy to both fix a pipe and write a newspaper article simultaneously.
The value of that “alternative use” that cannot be realized is called an opportunity cost.
Opportunity Costs are the possible uses of a resource that are sacrificed when resources are used in a different way. Formally, the opportunity cost is the value of the second-best alternative use sacrificed when a resource is consumed.
Example A: A child is given one hour of recess. He can either play on the swings or play on the slides – he cannot do both with the same minutes (resources). By choosing to play on the swings, he sacrifices the opportunity to spend the time on slides (opportunity cost).
Example B: A business manager invests $500,000 in Company A with returns of $5,000.00 per year. He later learns he could have had returns of $7,500.00 per year. His opportunity cost is $7,500.00 – $5,000.00 = $2,500.00.
Example C: A company spends $75.00 purchasing materials from their supplier. Their opportunity cost is $75.00 . . . the vale of other objects they could have purchased with that money.
All resources with more than one possible use generate opportunity costs. If you use your water for cola, it cannot be simultaneously used for tea and coffee.
We divide business-oriented opportunity costs into two overarching categories:
- Explicit Costs
- Implicit Costs
Explicit Costs are the easiest to calculate and the most emphasized by management and financial officers. Explicit Costs are the cost of resources purchased from external third parties (from the market for finished goods and services and the market for factors of production).
The resources purchased are called market-supplied resources and include labor, land, raw materials, factories, taxes, utilities, delivery services, and more. In the modern world, such resources are purchased with money making the value easy to calculate.
Example: A company purchases labor for $25,000 in labor; a delivery van for $3,500; and machinery for $7,500. That money could have been used for any number of other purposes, thus opportunity costs of $36,000.00 arise.
Implicit costs are more complex. Explicit costs are costs paid by the company itself and implicit costs are paid by the owner or investor specifically. Implicit Costs are the value of resources sacrificed by the owner for the sake of the company.
Typically, implicit costs occur when an owner donates or offers resources to the company that have alternative uses. The resources involved are called owner-supplied resources. There are two key differences between explicit and implicit costs:
- Who pays the cost?
- Implicit Costs: Owner Pays
- Explicit Costs: Company Pays
- Kinds of resources involved?
- Implicit Costs: Generally non-monetary
- Explicit Costs: Generally monetary
Consider the following examples of implicit costs:
- Owner works in the company without pay to help with operations. (Time)
- Owner donates some unused land to the company for a new store (Land)
- Owner provides office supplies (pencils, paper, ink) from his home (Materials)
In addition to actualized costs, implicit costs can include lost potential profits the owner could have made on his investments or resources. For example, the owner invests $100,000 into the company for returns of $10,000 annually. An alternative investment would have generated returns of $15,000 annually. This owner has sacrificed $5,000 in potential profits = implicit costs.
Important! The original financial investment is not calculated in implicit costs. This is because, unlike other resources – money provided to a company as an investment still belongs to the owners, it is not a cost. This is also to avoid counting the costs twice – once when the owner gives the money to the company and once when the company uses it to purchase materials.
Example: Michelle is investing $50,000 in her restaurant, in return for $17,000 in annual returns. There was an alternative investment that would have generated $18,000 in annual returns that she passed up. Michelle also donated 250 apples from her farm valued at $300 in the marketplace.
The implicit costs include actualized + lost potential profits:
It is possible for the company itself to face lost potential profits (opportunity costs). Examples include money lost on investments, in market selection, in project management, etc.
Example: A company invests $100,000 in a new land development that generates $150,000 returns. They could have invested the $100,000 in a different opportunity for $170,000 in returns but choose against it.
There is a $20,000.00 opportunity cost in lost potential profits from using their money in this way. To calculate lost potential profits = (Opportunity Benefit – Opportunity Cost) = ($150,000 – $170,0000). These lost potential profits are generally only relevant in project or investment opportunity analysis and are normally estimated. Consequently, they are often NOT calculated in Explicit Costs by the company’s financial papers (Balance Sheets, Income Statements, Cash Flow Statements). They would theoretically be a form of Implicit Cost in that it is money the owner should have received but did not (lost potential profits for the owners).
Total Economic Costs
How companies assess and calculate costs depends on the situation.
If trying to identify actual financial costs spent by a company over the year, consider Actualized Explicit Costs.
When considering the value of an upcoming project or new company investment, consider both Explicit Costs and relevant Implicit Costs
When a company is considering the total costs (actualized and lost potential profits) from their operations, they identify the Total Economic Cost = Explicit Costs + Implicit Costs. This figure is very significant to owners and investors as it reflects not only the company’s costs, but the separate owner’s losses as well.
Because there are different ways to calculate costs – there are different ways to calculate profits as well.
The difference lies in whether costs include implicit costs or not.
Accounting Profit only takes into consideration money spent by the company (Explicit Costs). This figure, while not all-encompassing does focus on the most valuable resource the company has – it’s money. Financial and accounting officers are responsible for monitory the accounting profit and ensuring the company is both increasing in profits and generating sufficient money for operations to continue. This is the figure seen on Balance Sheets, Annual Reports, and Income Statements.
Economic Profit is of greater significant to owners and investors, taking into calculation both Implicit and Explicit Costs. This figure is less reliable (often including estimates) but does give a better understanding of what resources the company is draining in operations.
|Opportunity Cost||Those things that motivate one to choose Option A.|
|Trade-Off||The costs associated with making a decision, occurring where a choice has a resulting sacrifice required.|
|Profits||Revenue – Cost = Profit|
The money the owners make from a transaction in the end.
|Explicit Costs||The cost of resources spent in external markets.|
|Market Supplied Resources||Resources purchased from external markets in exchange for explicit costs.|
|Implicit Costs||The cost of resources sacrificed by the owner specifically for the sake of the company.|
|Owner Supplied Resources||Resources received from owners, generating implicit costs|
|Total Economic Cost||Explicit Costs + Implicit Costs|
The total cost of the business for the owners and investors.
|Accounting Profit||Revenue – Explicit Cost|
The financial profit
|Economic Profit||Revenue – Total Economic Cost|
The overall profit