Opportunity cost Model Meaning, Advantages and Limitations

This method was first advocated by Kiman and Jones for a company with several divisional heads bidding for the services of various people they need among themselves and then include the bid price in the investment cost.

Opportunity cost is the value of an asset when there is an alternative use of it.

There is no opportunity cost to those employees that are not scarce, and also, those at the top will not be available for auction. As such, only scarce people should comprise the value of human resources.

The value of a human resource is determined based on the value of an individual employee in alternative use. If an employee is hired from an external source, there is no opportunity cost to him.

Benefits:

Relative Price: Another important benefit of considering your opportunity cost is it allows you to compare relative prices and the benefits of each alternative. Compare the total value of each option and decide which one offers the best value for your money. For instance, a business with an equipment budget of $100,000 may buy 10 pieces of Equipment A at $10,000 or 20 pieces of Equipment B at $5,000. You could buy some of A and some of B, but relative pricing would mean comparing the value to you of 10 pieces of A versus 20 pieces of B. Assuming you choose 20 pieces of B, you effectively decide this is more valuable to you than 10 pieces of A.

Awareness of Lost Opportunity: A main benefit of opportunity costs is that it causes you to consider the reality that when selecting among options, you give up something in the option not selected. If you go to a grocery store looking for meat and cheese, but only have enough money for one, you have to consider the opportunity cost of the item you decide not to buy. Recognizing this helps you make more informed and economically sensible decisions that maximize your resources.

Limitations:

• The total valuation of human resources for the competitive bid price may be misleading or inaccurate. It may be because a person may be an expert for one department and not so for the other department. He may be a valuable person for the department in which he is working and thus commands a high value but may have a lower price in the bid by the other department.
• It has specifically excluded from its preview the employees scarce or not being ‘bid’ by the other departments. This is likely to lower the morale and productivity of the employees who are not covered by the competitive process.
• Under this method, valuation based on opportunity cost is restricted to alternative use within the organization. In real life, such alternative use may not be identified because of the constraints in an organizational environment.
• Opportunity costs take time to calculate and consider. You can make a more informed decision by considering opportunity costs, but managers sometimes have limited time to compare options and make a business decision. In the same way, consumers going to the grocery store with a list and analyzing the potential opportunity costs of every item is exhaustive. Sometimes, you have to make an instinctive decision and evaluate its results later.