An example of opportunity cost application in advanced management accounting

An example of opportunity cost application in advanced management accounting

 

Regarding the topic of opportunity cost in advanced management accounting, please provide an example with some calculation of how it is applied so as to clarify the topic a bit more.

Opportunity cost in advanced management accounting is the benefit sacrificed from the best alternative use of a scarce resource. It is usually a relevant cost even though it may not appear as a cash payment or in the general ledger: managers must include it when capacity, labour, machine time, shelf space, materials, or capital is constrained.

Core idea

Suppose a business has only 800 staff-hours of warehouse packing capacity this month. If it accepts a new order that uses those hours, it may have to reject or reduce an existing, profitable product line.

The opportunity cost of the new order is not “all revenue from the alternative.” It is the contribution forgone from the best displaced alternative:

Opportunity cost = Sales revenue forgone − Variable costs avoided

Equivalently, where the constrained resource is measured in hours:

Opportunity cost per constrained hour = Contribution per unit x Hours required per unit 

Contribution means sales revenue less variable costs. Unavoidable fixed costs are normally excluded from this short-term decision because they will be incurred regardless of the decision. Relevant-cost analysis focuses on future cash flows that change because of the decision.

Worked example

Assume your online retailer is already operating at full packing capacity. It regularly sells Product B and is offered a one-off corporate order for a new Special Pack (S).

Item	Product B: normal business	Special Pack S: new order
Selling price per unit	HK$150	HK$165
Variable product, packaging and delivery cost per unit	HK$105	HK$70
Contribution per unit	HK$45	HK$95
Warehouse staff-hours per unit	0.5 hours	1.0 hour
Contribution per staff-hour	HK$90	HK$95 before opportunity cost

The special order is for 200 units. It will require:

200 units×1 hour=200 staff-hours

Because capacity is fully used, those 200 hours must be taken away from Product B. Since Product B requires 0.5 hours per unit, the business would have to give up:

200 hours / 0.5 hours per B unit=400 units of Product B

The contribution forgone on Product B is:

400 units×HK$45=HK$18,000

Therefore, HK$18,000 is the opportunity cost of accepting the special order.

Decision calculation

A relevant-cost comparison should include both the new order’s direct variable costs and the contribution lost from Product B.

Relevant item	Calculation		HK$
Relevant item		Calculation			HK$
Revenue from Special Pack S		200×165			33,000
Less: Variable cost of Special Pack S		200×70			(14,000)
Contribution from Special Pack S before capacity effect		33,000−14			19,000
Less: Opportunity cost—contribution lost on Product B		400×45			(18,000)
Net financial benefit of accepting S		19,000−18,000			1,000

The business should accept the special order at HK$165 per unit because it improves total short-term profit by HK$1,000.

However, the result is much less attractive than it initially appears. Looking only at the Special Pack’s direct contribution would suggest an additional profit of HK$19,000. Once the scarce warehouse capacity is recognised, the genuine benefit is only HK$1,000.

** reference:  a collection of management accounting notes