Question

What is an opportunity cost? Should it be included in the incremental cash flows for a project? Why or why not?

Answer 1

Opportunity cost is the benefit that is being missed out when one alternative is selected over the other. Suppose a company has a lying warehouse which it can rent out for annual rent of $10,000. It decides to start using the warehouse for storing its new product line that it will start producing. Thus the opportunity cost here is $10,000 in the form of lost rental income.

Yes, opportunity costs should be included in incremental cash flows. This is because opportunity costs are nothing but revenue lost when the existing resources are moved from their current use to another use. Hence they should be included in incremental cash flows that will arise in future. Opportunity costs are incremental in nature as they are part of the net additional (opportunity costs will be in the form of negative cash flow) cash flows that will accrue when a project is undertaken.