Finance for Managers: Core Concepts and Decision-Making

Opportunity Cost in Capital Budgeting

Opportunity cost is represented by the difference in return between one investment and another that is refused. In other words, opportunity cost is the benefit obtained by choosing an alternative action over another. This is a decision-making method that we can apply in our daily lives, and not only when making accounting decisions. Moreover, opportunity cost does not necessarily need to address money—it applies to any choice involving competing alternatives.

Opportunity cost is one of the instruments used in making capital budgeting decisions. In addition, opportunity cost can help companies in manufacturing industries determine the most appropriate production technique. They can choose capital-intensive or labor-intensive production methods based on each option's opportunity cost. When an apparel manufacturing company decides to invest in producing long-sleeved shirts instead of short-sleeved shirts, the income that short-sleeved shirts would have generated is an opportunity cost. Companies must deal with such decisions almost daily, which improves their decision-making skills if they are able to analyze and interpret the results of their choices.

The most critical step in the capital budgeting process is cash flow estimation. This estimation is influenced by several factors, including sunk costs, opportunity costs, externalities, net operating working capital changes, and salvage values. The complexity of these factors has increased companies' focus on this activity. Specialists in the field recommend that to properly estimate a company's cash flow, it is important to consider only incremental cash flows (Brigham & Houston, 2012). This type of cash flow is associated with expansion projects and reflects only the changes in the firm's total cash flow that result directly from the investment decision.

Legal Actions Versus Ethical Actions

The main difference between legal actions and ethical actions is that legal actions are not necessarily ethical, while ethical actions are always legal. A legal action can be represented by a project manager receiving all the bonuses for a successful project and not sharing them with the project team. The action is not forbidden by law, but it is not ethical; an ethical action would be for the manager to share the bonuses with the team.

The case of executives allowing themselves large bonuses while their companies were going through difficult times, customers were dealing with extreme financial distress, and the national economy was suffering from the housing bubble's effects provides a stark illustration. It is obvious that such actions were not ethical. However, there was no legal act forbidding the grant of bonuses to these executives. This decision was criticized by all affected stakeholders: the media, customers, employees, and authorities. The lack of ethics in this case surprised an entire world and highlighted the gap between legal permissibility and moral responsibility in business.

Business Operations and Hidden Costs

It is common to walk into restaurants or other locations that are nearly empty, with few or no customers. Similarly, one might go to a movie and notice there are very few attendees. This does not necessarily mean the movie was poor—it may simply mean the viewing occurred early in the day or long after the film's release. The movie in question might have been an award-winning production with strong box office performance overall.

There are several reasons determining a restaurant owner's decision to keep it open during slow periods. One of the most important reasons is opportunity cost. Managers consider the gain that potential customers who might find the restaurant closed would provide. In other words, the lost revenue from turning away any customers who arrive is weighed against the costs of remaining open.

Another reason is communication and brand perception. If a restaurant were to close during slow times, this would send a negative signal to competitors and customers alike. Restaurant owners must maintain the appearance that they can afford to keep their business open. Closure during slow periods would suggest the business is not profitable enough, potentially damaging customer perception even if the restaurant reopens later. Thus, the most important cost that managers must address when deciding whether to open for lunch is opportunity cost. Managers must evaluate whether the income gained from potential customers served while open is greater than or equal to the costs of keeping the restaurant operational.