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Opportunity Cost -- The amount of income that could be earned if the economic resource was put to an alternative use.

Or "everything has a cost!"

Why do we make this statement? How does the answer to that question relate to management?

• Why does a manager think about opportunity cost?
• What is the relationship between opportunity cost and the common business goal of wanting to earn a profit?
• Why does an accountant probably not think about opportunity cost? What information is the accountant lacking?
• Which is the relevant financial statement when a manager is thinking about opportunity cost?
• How do managers incorporate the concept of opportunity cost into their thinking?
• Now, how do you describe opportunity cost?

Can we begin to answer these questions?

The basic premise:  Business owners almost always operate the business with some combination of owned resources and resources acquired from others, such as input suppliers, landowners, employees, and lenders. 

• These non-owners expect to be compensated for allowing their resource to be used in the operation of your business; for example, the landowner expects to receive rent, the employee expects to receive a wage, and the lender expects to receive an interest payment. 
• Business owners, like any other person who allows their resource to be used in operating the business, are entitled to be compensated for using their resources in the business.  For example, the business owner is entitled to receive the equivalent to rent when the business owner using his or her own land in the business.  Or, the business owner is entitled to receive the equivalent of a wage for the time the business owner spends operating the business.  Or the business owner is entitled to the equivalent of interest for the capital the owner invests in the business. 
• An opportunity cost arises from the economic resources owned by the business owner.

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The following table may help illustrate this idea.

Compensating others for providing resources for use in your business are recognized as costs on an income statement.  The return available to compensate the business owners for their resources is the "net income" or "accounting profit" on an income statement.  That is, the business owners are not likely to pay themselves for the use of their resources; they simply keep whatever is left from the revenue after the costs are paid.

Net income reflects the shaded cells.

A key question is whether this residual is enough to justify that the business owners continue to operate the business.  For example if a landowner is not paid rent, the landowner will shift the land to another use that pays a rent.  Likewise, the business owners need to decide if the business is generating enough return to justify keeping the land in the current business.  If no, the business owners would be expected to shift the land to an alternative use.

Only the business owners can make this assessment; that is "is the accounting profit enough to justify the business owners continuing to use their resources in their own business?"

How much should the business owner expect as a minimum return?  Managers begin to answer this question by determining what the owners are investing in the business and how much return the owners want to justify staying in the business.  This thought process could start with "how much would I receive if I discontinued the business and shifted the resources to another use?"  That statement sounds like opportunity cost; that is, "how much income would I receive if my resource was put to an alternative use?".

Example:  if the net income for the business is $10,000; that is the amount the business owners are receiving for their investment in the business.  Their investment in the business could include their land, capital, time, and the risk they were exposed to.  But is $10,000 an adequate return?

To answer this question, the business owners might consider, for example,

• "if we did not use our land in our business, we could lease it to another business for $2,500."
• "If we did have our capital invested in this business, we could convert it to cash, loan it to another business and earn $3,000 in interest."
• If we did not work in our business, we could be employed by other business persons and earn $2,600."

If we now subtract these amounts ($8,100) from our net income ($10,000), the remaining $1,900 is our return for our information and risk exposure.  In this example, the business owner assumed that the $8,100 is an adequate return for their land, capital and labor.  They must now decide whether $1,900 is an adequate return for their information and risk exposure.

Example:  The business owners feel that the land should generate $3,500 in rent, their capital should generate $3,500 in interest, and the labor should generate $3,500 in wages.  In this case, the $10,000 net income is not enough to compensate the owners for their resources.  Even without placing any value on their information and risk exposure, the business is already $500 short (10,000 -10,500).  In this second example, the business owners might quickly recognize that the business is not generating enough net return to justify continuing to operate the business.

Managers could perform this analysis in numerous ways.  For example, the manager may decide to place a "cost" on their labor, information and land, and then assess whether the remainder of the net profit was adequate to compensate for their capital investment and risk exposure.

Regardless of how the managers address this question, they need to assess whether the net profit is adequate to justify their continued investment in and operation of the business.

There will be times when the business owner will accept less than the opportunity cost, such as, "even though I could earn more doing something else, I receive utility (pleasure, pride) by owning and operating a business.  Therefore, I am willing to accept a slightly lower return on my resources than I could receive from an alternative use so I can continue to operate my own business."

• Note the role that the business owner's goals have in this assessment process.

Only the business owner can make that assessment!!!

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Financial analysis

As an introduction to this subtopic (financial analysis), consider "why do we organize this information about our business into these documents or statements?" What is the purpose of preparing these financial documents? What is the purpose of analyzing this financial information (as we will discuss in this section)? How do the answers to these questions relate to topics previously discussed in this course?

HINT -- review the role of goals in the decision making process; also recognize (do not overlook) that goals play a role in several steps of the decision making process.

Review -- what does the balance sheet reveal about the business? What does the income statement reveal about the business? What does the cash flow statement reveal about the business?

In analyzing the financial performance of a business, does it help to review the economic resources used to operate a business?

What does a series of balance sheets reveal about the business? What does an income statement for the past reveal and what does an income statement for the future (a projected income statement) reveal? What does a projected cash flow statement reveal?

What do these statements collectively reveal? (see the next topic)

Rate of return on assets (ROA) -- profit plus interest expense for the time period (as calculated on the income statement) minus opportunity cost for unpaid labor and management divided by the total value of assets (as reported on the balance sheet).

• Example.  Income statement reports adjusted profit of $12,000 for 20XX; the balance sheet reports total assets of $200,000; this would be a rate of return on assets of 6%

ROA is based on the shaded cells

If there is a major change in value of assets during the period being analyzed (as revealed by the balance sheet from the start of the period and the balance sheet from the end of the period), a manager may want to average the value of the assets from the two balance sheets to determine the value of assets to use in computing return on assets.

• Example. The income statement reports profit of $12,000 for 20XX and the balance sheet on January 1, 20XX reports assets of $100,000 whereas the balance sheet on December 31, 20XX reports assets of $200,000. The average assets for 20XX would be $150,000, for a rate of return on assets of 8% (12,000/150,000).

Rate of return on equity (ROE) -- profit for the time period (as calculated on the income statement) minus opportunity cost for unpaid labor and management divided by the equity as calculated on the balance sheet.

• Example.  $12,000 adjusted profit from a business with $110,000 equity would be earning a rate of return on equity of 10.9%.

ROE is based on the shaded cells

A business' ROE should be greater than its ROA. This indicates that the business is increasing its profit by borrowing. If ROA exceeds ROE, the business may want to consider whether it wants to use some of its assets to reduce its debt.

An ROE that exceeds an ROA is consistent with the idea that the business is assuming additional risk by borrowing to expand its business. The additional profit (as indicated by ROE > ROA) is consistent with the idea that successfully assuming risk leads to additional profit.

Resource: Financial Characteristics of North Dakota Farms 2001-2003; give special attention to the definitions and explanations on pp. 7-10 of the pdf file.
Resource: Kay, et al. Farm Management , McGraw Hill, 5th Ed. 2004, p. 130.
Resource: Edwards, W. Financial Performance Measures, Iowa State U. File C3-55.
Resource: Edwards, W. Interpreting Financial Performance Measures, Iowa State U. File C3-56.
Resource: excerpt from Reff, T.L. et al. Analyzing Your Farm Financial Statements, NDSU Extension Service, EC-920. The focus of this excerpt is on 1) understanding why the "bottom lines" of a business' financial statements (i.e., balance sheets, income statement, and cash flow statement) differ and 2) interpreting those differences as part of the business analysis.

Financial Goals

• Again, what role do goals (financial as well as other goals) have in decision making? What process can be used to establish short- and long-term business and personal goals?
• What goals might a business have other than earning a profit? What goals other than earning a living might an individual have?
• What aspect of financial management or financial analysis can an accountant perform and what aspect of financial analysis must the manager perform? Why?