When your business is considering purchasing an asset, it is easy to get hung up on the price of the asset and not consider the opportunity cost that might arise if you do not purchase the asset or choose a different option.
Opportunity costs are important to consider, as they can help you determine the real value of the asset you intend to buy. Now, let's take a look at what the opportunity cost is so that you can make better financial decisions for your business.
What is the Asset Cost?
The cost of an asset is simply how much money it costs to purchase it. It might also include additional transaction fees, taxes, transportation costs, maintenance expenses, and other direct costs related to owning and using the asset. However, the key here is that these costs are quantifiable, trackable, and can easily be recorded.
As mentioned, the black-and-white nature of asset costs makes them easy to understand. As a result, many businesses focus on this aspect to the exclusion of everything else.
What is the Opportunity Cost?
Opportunity costs are a little more difficult to quantify as they represent the potential benefits that might accrue if you were to use the asset for business purposes. Essentially, the opportunity cost amounts to the revenue-generating opportunity that you would have had with the asset in your possession, minus the cost of the asset.
An example might be the purchase of an excavator. Let's presume that the excavator will cost $5,000 per month to purchase. Let us also presume that there is a fairly certain opportunity to make $12,000 a month through the use of the excavator. By not purchasing the excavator, you will not be able to earn that $12,000.
Therefore, the opportunity cost is $12,000 a month in potential earnings minus the $5,000 a month it would take to purchase the machine, which comes to $7,000 a month. Therefore, we can deduce that the opportunity cost of not buying the excavator would amount to $7,000 a month in lost income. This is money that could have been earned but will not be earned without the asset. It represents an opportunity lost.
Understanding this will help you determine whether the purchase of an asset is a good investment or not. Next time you consider purchasing an asset for your business, carefully consider the opportunity cost in conjunction with the asset cost before making a decision.
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