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.
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.
