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Out-of-pocket costs refer to direct expenses incurred in a project, while opportunity costs are indirect financial losses. They can include initial expenses, ongoing payments, and maintenance costs. Opportunity costs are expenses that cannot be classified as out-of-pocket costs.
An out-of-pocket cost is the sum of money that an individual or entity spends on a particular project. Total cost consists of the combined out-of-pocket cost and opportunity cost. The first describes various types of direct expenses, while the second consists of indirect financial losses that a person or entity may incur as a result of embarking on a particular project.
In many cases, an out-of-pocket cost is an initial expense incurred at the start of a project. When someone finances the purchase of a new home, the lender will typically require the buyer to make a principal payment known as a deposit at the time of purchase. This payment is an example of an out-of-pocket cost. When cash savings are used to make a purchase, accounting laws in many countries require the buyer to record the transaction as a capital outlay.
In addition to advance payments, out-of-pocket costs can be recorded in the ledger, even if that out-of-pocket has not yet occurred. When a purchase is financed, the ongoing principal and interest payments that the buyer pays to the lender are an example of an out-of-pocket cost. Depending on regional accounting laws, a borrower may be required to list anticipated finance costs as liabilities in a general ledger, even if those costs are spread over multiple years.
In addition to purchase payments, out-of-pocket costs may also include repair and maintenance costs. When a business purchases a copier machine, the initial outlay covers the cost of purchasing the machine, but the machine may not function properly unless the business hires a contractor to maintain the machine. Contractor fees and replacement parts are out-of-pocket costs incurred as a result of the company’s purchase of the machine. Also, a photocopier won’t work without ink and paper, which means the cost of purchasing these materials is another example of expense.
Expenses that cannot be classified as out-of-pocket costs are normally recorded as opportunity costs. When a business owner decides to purchase a photocopier so company advertisements can be printed and delivered to employees, in addition to incurring the obvious out-of-pocket cost, the business owner may also have incurred an opportunity cost. If the business owner had chosen to purchase email software so notices could be sent electronically instead of printed on paper, the company would have avoided the long-term cost of purchasing paper and ink. Thus, out-of-pocket costs are tangible expenses, while operating costs generally imply missed opportunities to generate revenue or reduce costs.
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