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When evaluating a business project, a textbook recipe is to take incremental income from the project and subtract the incremental costs -- including opportunity costs -- to arrive at the incremental result*. When choosing among competing projects, one compares the incremental results and chooses the project with the highest one, ceteris paribus.

I am a little bothered by the treatment of opportunity costs here. I also think there is a conceptually simpler alternative**. I wonder what, if anything, could go wrong if we first evaluated each possible project (in the broadest possible sense so as to include everything the business owner could do with his/her resources***) without subtracting opportunity costs and then compared the results across projects. Would that possibly yield a different result?

*Incremental result and such is probably not the standard terminology. Feel free to suggest how to rephrase in standard terms.
**What is conceptually simple vs. difficult can of course be debated.
***This has been edited in response to the example of @1muflon1. I count becoming an accountant as one of the projects under consideration. If this thought/project is in our universe, it has to be evaluated alongside all the other alternative projects.

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Omitting opportunity cost can lead to different outcomes. Consider a trivial example:

You can set up a business with revenue \$1000 and costs \$500 making your accounting profit \$500. Now suppose your second best choice to setting up the business is to become an accountant where you could earn net salary of \$750. This forgone salary becomes your opportunity cost since following Buchanan (1991) opportunity cost is simply:

the evaluation placed on the most highly valued of the rejected alternatives or opportunities. It is that value that is given up or sacrificed in order to secure the higher value that selection of the chosen object embodies.

If you ignore opportunity cost you record \$500 accounting profit, but if you calculate economic profit by including opportunity cost of forgone salary you will find that your economic profit is -\$250.

This would change your decision as in a long run you should not pursue a project that yields negative profit (if you are rational profit maximizing agent). So in this case you will take the option of not to undergo the project if you correctly account for opportunity cost, but if you omit it you will incorrectly pursue the project as it seemingly yields positive profit.

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  • $\begingroup$ Thank you for a simple and clear answer! Perhaps I was not clear enough in my formulation, but I would definitely consider becoming an accountant as one of the possible projects. If we have this possibility in our universe, it has to be evaluated alongside all other projects. Now with that out of the way, could we get rid of alternative costs in project evaluation? $\endgroup$
    – Richard Hardy
    Jun 14, 2021 at 15:41
  • $\begingroup$ @RichardHardy It would still change the profit calculation for each individual project. In some simple scenario with discrete choice between some simple choices it might make no difference but in some more complex scenarios it might. For example, suppose that in order to do anything in the example above you need to earn at least \$300 because your utility function is such that for taking no action and enjoying free time you receive utility equal of \$300. In the scenario above accounting profit of running business is \$500 accounting business of working is \$750, but economic $\endgroup$
    – 1muflon1 ♦
    Jun 14, 2021 at 16:12
  • $\begingroup$ profits are -\$250 and \$250 respectively. If you need to earn at least \$300 to be compensated for the fact that you do something as opposed to enjoying leisure than it would change the decision as now none of the actions exceed the threshold. $\endgroup$
    – 1muflon1 ♦
    Jun 14, 2021 at 16:14
  • $\begingroup$ the main complication seems to be introduction of another alternative (leasure) and putting a utility function on top of the monetary outcomes. My response would be, include all alternatives/projects in the comparison (leasure, business, accounting), obtain their monetary outcomes (\$300 equivalent, \$500, \$750), turn into utilities ($u_1$, $u_2$, $u_3$), and pick the one with maximum utility. The problem should be solved. Or is that not possible? Also, I lost you at how the economic profits are \$-250 and \$250. How did you get those numbers? $\endgroup$
    – Richard Hardy
    Jun 14, 2021 at 17:33
  • $\begingroup$ Also, I am not sure if you meant to measure utility of the increments in wealth and leisure or the utility of total wealth and leisure, but again I do not see a conceptual difficulty with either of these. It seems that fundamentally we are dealing with the same information but presented in a different way, e.g. something equivalent to $a$ vs. $b$ vs. $c$ (my approach) or $a-c$ vs. $b-c$ vs. $c-b$ (alternative cost approach) for some set of alternatives with utility outcomes or perhaps just monetary outcomes $a<b<c$. $\endgroup$
    – Richard Hardy
    Jun 14, 2021 at 17:37

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