Understanding Opportunity Cost: What Does It Mean And How Does It Benefit Companies?

‍What is opportunity cost?

The meaning of opportunity cost is the value of what you lose when you choose one option over another. Opportunity cost measures value not just in terms of the money spent but also time and other non-monetary resources. Warren Buffett sums it up in clear terms when he says, “The real cost of any purchase isn’t the actual dollar cost. Rather, it’s the opportunity cost – the value of the investment you didn’t make, because you used your funds to buy something else.”

One thing to remember when calculating opportunity cost is to not only focus on flat returns on investment but to also factor in the level of risk in your options.

Here’s a simple opportunity cost example: A start-up has SGD 20,000 in funds that it plans to invest. It has two choices. Option A is to buy new equipment while Option B is to invest the money in stocks. If the business eventually decides on Option A and buys fresh equipment, then the potential profit it missed out on by not investing in stocks is the opportunity cost.

Opportunity cost can be positive or negative. A positive opportunity cost means a profitable decision where the potential gain is higher than the potential loss. A negative opportunity cost points to an unfavourable investment choice where the potential loss is higher than the potential gain.

What is opportunity cost used for? Opportunity cost lies at the heart of smart decision-making in business, especially investment choices. It can be used to weigh the pros and cons of decisions before they are taken, and in some cases to calculate the gains and losses of past decisions.

Why is opportunity cost important?

Improves decision-making

Opportunity cost helps businesses make informed decisions. Your decisions as an entrepreneur or investor impact every aspect of your business – from your products and services to the way you manage your finances and deal with customers and clients. Opportunity cost allows you to compare the costs and benefits of the various choices you are considering and pick the best option. Remember that opportunity cost cannot be calculated with absolute certainty. But a careful calculation and assessment of opportunity cost definitely has a positive impact on decision-making.

Benefits small businesses

Opportunity cost is a beneficial tool for small businesses and start-ups that have fewer resources to work with than larger and more established companies. Instead of wagering their limited funds on decisions taken on instinct and gut feeling, calculating and analysing opportunity costs can help them make wiser choices when spending money and get greater returns on their investment while avoiding risks.

Prevents costly mistakes

Even the best decisions can at times unravel when implemented. Weighing your options thoroughly and making an informed selection significantly reduces your chances of making costly mistakes, incurring unnecessary expenses, and being embarrassed down the line. Considering your other alternatives through the lens of opportunity cost also prepares you for any consequences and helps you think of solutions long before the problem worsens.

Fewer missed opportunities

Every business owner contends with missed opportunities now and then. But some of these opportunities might hold the potential to completely alter the course of a business and take it to great heights. Making opportunity cost a familiar concept in how you do business will ensure you don’t lose out on the great opportunities that come your way.

What are the types of opportunity cost?

There are two types of opportunity cost – explicit cost and implicit cost.

• Explicit cost includes expenses that have a clear dollar value and are found on accounting sheets. They have a direct impact on cash flow and can be fixed or variable. Salaries, rent, utilities, raw material and equipment costs, and stock purchases are examples of explicit costs.
• Implicit costs are less tangible than explicit costs. This means they cannot be assigned a dollar amount and, therefore, cannot be recorded in the accounts. Time spent by an employee on maintenance work or by a recruit on training are examples of implicit cost. The employees’ time cannot be given a monetary value but can still be measured in terms of how it could have been otherwise spent (working instead of training, for example).

How does opportunity cost affect my business decisions?

Improving decision-making and making the most of each opportunity goes a long way in running a successful business. As entrepreneurs and investors, you can benefit from making it a habit to understand the opportunity cost of each decision. Studying the potential costs and benefits of each choice and their impact on your business will ensure you make an informed decision. That doesn’t necessarily mean picking the option with the highest expected return but one that will lead to the best possible outcome while also aligning with your organisational goals.

You can follow these simple steps to conduct a thorough opportunity cost analysis:

• Identify and list the direct costs related to each decision.
• List the potential benefits (profit, increased productivity, etc). 
• If possible, quantify the costs and benefits by assigning a monetary value to each.
• Now, make a list of potential risks and uncertainties. Be sure to include factors that can impact your decision – such as resource availability (funds, raw material, workforce, etc), time constraints, market conditions, geopolitical factors, etc.
• Don’t forget to account for your short-term and long-term organisational goals and overall business strategy.
• With all this information, evaluate each option using the opportunity cost formula given below.

How to calculate opportunity cost

The opportunity cost formula is: Opportunity cost = FO - CO

FO stands for ‘return on best forgone option’

CO stands for ‘return on chosen option’

Opportunity cost examples

Example 1

You have SGD 50,000 in company funds that are earmarked for investment. Option A is to invest it in the stock market, which is expected to give you a 16% return on investment in a year’s time. This works out to SGD 8,000. Option B is to re-invest in the business by using the funds to launch a new product. You estimate that the new product launch will get you a return on investment of 12% in the first year, or SGD 6,000. Therefore, an opportunity cost analysis will tell you that Option A is the more profitable alternative. Using the opportunity cost formula mentioned above, the opportunity cost in this case is SGD 2,000 (SGD 8,000 - SGD 6,000).

This is a short-term analysis for a year. Here’s how to calculate opportunity cost for a longer period. By going with Option A, your company stands to gain SGD 9,000 in the second year and then SGD 12,000 in the third year. In the case of Option B, the return on investment is SGD 10,000 in the second year and SGD 18,000 in the third year due to an expected spurt in demand for the new product. Therefore, an opportunity cost analysis for a three-year period reveals that Option B is more profitable in the long run. Here, opportunity cost is SGD 5,000 (SGD 6,000 + SGD 10,000 + SGD 18,000 - SGD 8,000 - SGD 9,000 -SGD 12,000).

Example 2

Your company directors are divided on hiring a new marketing director or buying marketing automation software. A new director will cost the company SGD 250,000 a year in salary and bonuses. The software is state-of-the-art and will cost SGD 15,000 for the initial set-up and SGD 4,000 per month thereafter. Looking at a five-year period from a purely expense point of view, new software will cost way less than a new director. However, your opportunity cost analysis must take into consideration the profit a marketing director could earn the company in terms of new ideas and campaigns in comparison to the money you might save simply by buying software to optimise the marketing team’s workflow.

Accounting profit vs economic profit

Opportunity cost is the value of profit made or lost due to a business decision. But what kind of profit is this? There are two types of profits:

• Accounting profit, which is the money a company is left with after deducting all its explicit expenses from its total revenue. Accounting profit is calculated for a specific period, such as a quarter or a year. It is found at the end of your income sheets, due to which it is also referred to as the bottom line.
• Economic profit is total revenue minus explicit cost and opportunity cost. As it accounts for opportunity cost, economic profit is more theoretical in nature. Unlike accounting profit, which is used as a measure of a company’s financial health, economic profit helps companies plan strategy (entering a new market, scaling down operations, etc) and make important decisions.

Differentiating between opportunity cost and other costs 

Apart from opportunity cost, there are other costs that are relevant to the decision-making process:

Opportunity cost vs sunk cost

Sunk cost is money a company has already spent and cannot recover. How does it differ from opportunity cost? Here’s an example to explain: A company spends SGD 10,000 on new machinery in order to increase production volume and serve a larger market. This is the sunk cost. Now, imagine if that amount was instead invested in the stock market, earning SGD 1,000 within a year. The difference in revenue earned in each scenario is the opportunity cost.

Opportunity cost vs risk

Opportunity cost compares the projected future value of one decision against the projected value of another decision while risk compares the actual value of an investment against its projected value. Therefore, a risk analysis determines the possibility of a company losing part or all of its investment. Risk and opportunity cost are both central to making investment decisions.

Opportunity cost vs marginal cost

Marginal cost is what a company pays to produce an extra unit of a product. It is calculated by dividing the change in production cost by the change in product quantity. Marginal cost helps companies determine the time it will take to sell a single unit for more than what was spent producing it and, thereby, achieve economies of scale. Marginal cost is closely tied to opportunity cost because by combining the two, you get marginal opportunity cost. Marginal opportunity cost compares the price of producing a product per additional unit and the value one might have derived by investing the same amount in another area of the business.

Opportunity cost vs trade-off

In business, a trade-off is a compromise you make when you pick one alternative over another. An example of a trade-off could be to make one investment decision while forgoing another. Or, it could be giving in to budget constraints and picking a smaller team for a one-time project in exchange for completing the work on time. While a trade-off reflects what is sacrificed to gain something else, opportunity cost measures the value of the second best alternative that was given up. Trade-offs are a hurdle to efficient decision-making. But by assessing the opportunity cost of your options, you can turn even a trade-off into a profitable venture.

Opportunity cost vs incremental cost

Incremental cost is the extra cost of producing additional units of a product. For example, if a company produces 500 units at a time and has the production capacity to fit in another 100 units, then the expense it incurs to produce those extra 100 units is the incremental cost. Incremental cost is a variation of marginal cost, which accounts for the price of producing just a single extra unit. While they measure different things, both incremental cost and opportunity cost are central to financial decision-making.

Limitations of opportunity cost

Not 100% accurate

One drawback of opportunity cost is that it isn’t an exact science. Opportunity cost is calculated on the basis of estimates, past records, and even educated guesswork. A company might use its historical records to predict the outcome of a future investment but there is no guarantee it will be accurate. Furthermore, a sudden change in variables in the future can make you rethink your decision, but it might be too late. That said, opportunity cost is still useful as it offers valuable insights that can significantly improve your investment decisions.

Difficult to quantify at times

Opportunity cost does not only consider monetary value. It also accounts for non-monetary value (time, experience, risk, etc) for which assigning a dollar value might be an impossible task. Let’s say a factory relocates to a remote suburb to save on rent. However, the relocation means that employees must commute an extra two hours every day. Here, the opportunity cost must not only consider the rent money saved but also the additional commuting time, which might have been better spent if the factory had taken a different decision.‍

Subjective in nature

Opportunity cost is subjective in nature. What one company considers a high opportunity cost might not be the same for another company. Opportunity cost is dependent on the circumstances, preferences, and values of individual businesses and there is no one answer that fits all situations.

Not recorded

Due to the fact that opportunity cost is primarily concerned with future events and based on estimates, accountants and finance teams do not include it in the company’s financial statements and records. This means that opportunity cost is not relevant to the financial reporting process even though it is highly recommended for improved decision-making, investment, and strategic planning.

FAQs on opportunity cost

What is the meaning of opportunity cost in simple terms?

Opportunity cost is the money a business could have earned if it had taken a different decision.

How to calculate opportunity cost?

Opportunity cost = FO (return on best forgone option) - CO (return on chosen option).

Why is opportunity cost important?

Opportunity cost is critical to making investment decisions. That said, opportunity cost is omnipresent in both business and in life because every choice you make means there were alternative options you lost out on. Even taking no decision has an opportunity cost.

Is opportunity cost real?

Opportunity cost is a notional concept rather than an exact measurement. While it might not produce a concrete dollar value, it is a core concept in investment decision-making and financial analysis.

How is opportunity cost reflected in the company’s financial statements?

Opportunity cost is not recorded in financial statements.

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