The Opportunity Cost of Using Excess Capacity

Robyn McLaughlin, Robert A. Taggart and Jr.

Financial Management, 1992, vol. 21, issue 2

Abstract: When a new project proposal calls for the use of existing, but currently idle, facilities, an opportunity cost should be charged to the new project for using those facilities. Capacity in place gives the firm an option to produce. When capacity is not available, the firm has an option to invest. The true opportunity cost of using the excess capacity is the change in the value of the firm's options that is caused by diverting capacity to some other purpose. Techniques exist for estimating this cost, but we argue that they ignore the option elements of the problem. We show that the true opportunity cost can vary widely in different circumstances and that existing measurement techniques err primarily by focusing oil the cost of specific investment programs rather than on the value of a firm's production and investment options.

Date: 1992
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