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What Is Alternative Cost?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 23 July 2014
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Also known as opportunity cost, alternative cost is the value connected with the next-best choice of action that a business may choose to take. While not recognized as the ideal plan by the company, this secondary cost option essentially provides the company with a backup plan in the event that the course of action initially taken does not yield the desired results. Since the business has already identified the costs associated with the secondary opportunity, it is much easier to implement the approach when and as necessary.

It is important to note that alternative cost is not just about money. The figure represents a number of other forms of value as well. For example, the degree of pleasure received from the action is a key factor in determining this type of cost. Another factor is the usefulness of the resulting action, in terms of utility. Any benefit that can be derived from the action represents a portion of the alternative cost.

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The best way to understand how alternative cost functions is to consider an individual who has a significant sum of money to invest. After investigating all available options, and taking into consideration the general comfort level of the individual with investing, it is determined that the two best options would be to either invest the funds in a bond issue or place the money in a certificate of deposit at the local bank. If the individual chooses the CD, the interest that would have been earned on the bond issue represents the alternative cost, or the benefit that was forgone due to choosing the other option. In like manner, if the individual chooses to go with the bond issue, he or she forgoes the interest that would have been earned on the CD, which represents the alternative cost of that decision.

Alternative or opportunity costs are not about causing people to second guess their decisions. Rather, the concept helps them to determine what they have to give up in order to go with the best possible choice. At the same time, calculating the alternative cost does help to qualify each available option and make it possible to identify a viable backup plan, in case the first option does not yield the desired benefit. For example, if the investor who chose to invest in the bond issue decides that the deal is not yielding the expected benefits, there is always the option of going with a certificate of deposit once the bond issue matures.

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Charred
Post 4

@allenJo - Let’s get back to alternative energy for a moment. In my opinion, wind and solar energy are much cheaper than fossil fuels. After all, they’re free. You can’t beat free!

Granted not all sources of alternative energy (like ethanol) are the best source of energy but solar and wind will be around for a long time, and there is an infinite supply.

So to get back to your example, if you build the fossil fuel plant you will spend more money than if you set up the solar plant and the windmills.

David09
Post 3

@allenJo - I totally agree -- that's why we hear horror stories about humongous sums of money spent on earmarks and stuff.

No, the only opportunity cost they consider most of the time in my opinion is, “What am I giving up in terms of my chances to get elected if I go down this path?” I’m sorry to sound so cynical but that’s the sad state of affairs we find ourselves in at the moment.

allenJo
Post 2

@SkyWhisperer - I think our politicians need to think long and hard about real opportunity costs and not be swayed by lobbyists. As an example let’s make an alternative energy cost comparison.

Say you have a chance to go with a fossil fuel plant or a plant that produces ethanol. You decide to go with ethanol because you think it’s the smarter choice.

In the end, however, you discover that ethanol is more expensive, almost nobody is using it, and therefore you have few buyers. You gave up the fossil fuel plant because you thought it was a bad thing, but fossil fuels have been around for a long time and by comparison the plants are cheaper to build from what I understand.

But the politicians get swayed by rhetoric and lobby money. So they end up making decisions that are actually more expensive, thereby wasting money.

SkyWhisperer
Post 1

The opportunity cost principle is one of the best lessons you can learn in life in my opinion. I learned about it in economics and have never forgotten it.

Now and again I find myself thinking in terms of opportunity cost. For example, if I work at a dead end job that is going nowhere, I start to think of opportunity cost. I ask myself, how much time am I wasting at this job? Could I be advancing more in another job? If I keep the current position, what do I forego from what I could have gained in another job?

You get the idea. It applies to anything, really. Life is about making choices and attempting to choose the best among a bevy of alternatives.

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