Opportunity Costs.

An opportunity cost is associated with using a resource in one activity instead of another.

Every time we use a business resource (equipment, dollars,manpower, etc.) in one activity, we give up the opportunity to use the same resources at that time in some other activity.

Every day businesses use resources to accomplish various tasks-forklifts are used to transport materials, engineers are used to design products and processes, assembly lines are used to make a product, and parking lots are used to provide parking for employees' vehicles. Each of these resources costs the company money to maintain for those intended purposes. However, that cost is not just made up of the dollar cost, it also includes the opportunity cost. Each resource that a firmowns can feasibly be used in several alternative
ways. For instance, the assembly line could produce a different product, and the parking lot could be rented out, used as a building site, or converted into a small airstrip. Each of these alternative uses would provide some benefit to the company.

A firmthat chooses to use the resource in one way is giving up the benefits that would be derived from using it in those other ways. The benefit that would be derived by using the resource in this "other activity" is the opportunity cost for using it in the chosen activity.Opportunity cost may also be considered a forgone opportunity cost because we are forgoing the benefit that could have been realized. A formal definition of opportunity cost might be:

An opportunity cost is the benefit that is forgone by engaging a business resource in a chosen activity instead of engaging that same resource in the forgone activity.

As an example, suppose that friends invite a college student to travel through Europe over the summer break. In considering the offer, the studentmight calculate all the out-of-pocket cash costs that would be incurred.
Cost estimates might be made for items such as air travel, lodging, meals, entertainment, and train passes. Suppose this amounts to $3000 for a to-week period. After checking his bank account, the student reports that indeed he can afford the $3000 trip. However, the true cost to the student includes not only his out-
of-pocket cash costs but also his opportunity cost. By taking the trip, the student is giving up the opportunity to earn $5000 as a summer intern at a local business. The student's total cost will comprise the $3000 cash cost as well as the $5000 opportunity cost (wages forgone)-the total cost to our traveler is thus $8000.

A distributor of electric pumps must decide what to dowith a "lot" of old electric pumps purchased 3 years ago. Soon after the distributorpurchased the lot, technology advancesmade the old pumps less desirable to customers. The pumps are becoming more obsolescent as they sit in inventory.

The pricing manager has the following information.

Looking at the data, the pricing manager has concluded that the price should be set at $8000.

This is the money that the firmhas "tied up" in the lot of old pumps ($7000 purchase and $1OOO storge), and it was reasoned that the company should at least recover this costs. Furthermore, the pricing manager has argtied that an $8000 price would be $1500 less than the list price from 3 years ago, and it would be $4000 less than what a lot of new pumps would cost ($12,000 - $8000).What would be your advice on price?

SOLUTION

Let's look'more closely at each of the data items.

Distributor's purchase price 3 years ago: This is a sunk cost that should not be considered in setting the price today.

Distributor's storage costs to date: The storage costs for keeping the pumps in inventoryare sunk costs; that is, they have been paid. Hence they should not influence the pricing decision.

Distributor's listprice 3 years ago: If there have been no willing buyers in the past 3 years at this price, it is unlikely that a buyer will emerge in the future. This past list price should have no influence on the current pricing decision. ~

Current listprice of newerpumps: Newer pumps now include technology and features that have made the older pumps less valuable. Directly comparing the older pumps to those with new technology is misleading.

However, the price of the new pumps and the value of the new features help determine the market value of the old pumps.

Amount offeredfrom a buyer 2 years ago: This is a forgone opportunity. At the time of the offer, the company chose to keep the lot and thus the $5000 offered became an opportunity cost for keeping the pumps. This amount should not influence the current pricing decision.

Current price the lot could bring: The price a willing buyer in the marketplace offers is called the asset's market value. The lot of old pumps in question is believed to have a current market value of $3000.

From this analysis, it. is easy to see the flaw in the' pricing manager's reasoning. In an engineering economist analysis we deal only with today's and prospectivefuture opportunities.

It is impossible to go back in time and change decisions that have been made. Thus, the pricing manager should recommend to the distributor that the price be set at the current value that a buyer assigns to the item: $3000.

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