What is opportunity cost in business & how to calculate it?
Generally speaking, opportunity cost refers to the value any individual could have received but passed up in pursuit of another option. While the initial usage of opportunity cost was started by economists to determine the benefits of trade between different entities, its relevance has spread to other industries, especially businesses.
The choices businesses make all add up to determine how well a company will perform in the long run. To get the best out of decision-making, to help guide the process, the calculation of opportunity cost in business is not only important, but it is also a necessity.
In this article, we’re going to take a look at what opportunity cost is, some examples of it, how it affects decision-making in business, and how to calculate it. We’re also going to explore the common factors that shape business decisions, why opportunity cost is important and the difference it has with sunk cost.
Whenever you choose between two options your choice will come at a cost. This cost refers to the potential benefits or advantages you give up in exchange for the choice that you have made.
Therefore, the opportunity cost in business basically refers to this cost, the trade-offs you accept in exchange for the choice you make.
This choice could be relevant in many contexts. From investment decisions to resource allocation, you’re always going to have to make a choice.
Here are some common opportunity cost example in business to give you a better understanding of the concept:
1. When a company spends $1 million on interest for overall debt, the opportunity cost is the aspects of the business the money could have been spent on, like upscaling, marketing, or product development.
2. For a company choosing to produce phones, the opportunity cost would be any other product they could have manufactured, like computers or keyboards.
3. If you decide to give a holiday the opportunity cost is the work that could have been done that day.
4. A company buys a sofa for the office and with that same amount of money it could have bought a water cooler and new wallpaper. The opportunity cost here is the water cooler and the wallpaper.
5. If an employee chooses to quit their job for a year to pursue higher studies the opportunity cost they incur would be the wages they could have gotten for that year.
By calculating opportunity cost before making a decision you get a clear view of what you’re gaining in comparison to what you’re losing out on. Even if the scales are balanced you at least get a better idea of which trade-offs you would rather incur when compared with the value you are creating.
By this logic, calculating opportunity cost in business can do wonders for decision-making, here’s how:
● It can help guide investment decisions. When determining the profitability of any particular investment option the first metric that is calculated is the Rate of Rate or RoR. However, calculating the opportunity cost as well can help you gain further insight into the rationale behind your decision.
This way you’re not only looking at the direct monetary return but also the time, effort, utility, and overall effort required that indirectly affect company performance.
● It can also help you determine your capital structure. Finding opportunity cost behind the amount of debt or equity you choose to finance operations can help you make better decisions about how to structure your fiscal strategy.
In fiscal management there are two approaches to calculating opportunity costs - one simple opportunity cost formula and another more complicated, detailed one:
● Formula 1:
Opportunity Cost = Return on A (option not chosen) - Return on B (option chosen)
Opportunity cost is essentially the difference between expected (or actual) returns provided by two different options. You can either estimate the impact of an upcoming decision, or you can calculate the performance of historical choices made by using this formula.
● Formula 2:
NPV = FCF0 +(FCF1)/ (1 + r)1 +.......+(FCFn)/(1 + r)n
NPV = Net Present Value
FCF = Free Cash Flow
r = Discount rate
n = Number of periods
This approach to calculating opportunity cost is done by factoring it into the NPV or Net Present Value formula. In the face of two mutually exclusive options the governing rule that guides decision-making is the NPV value, i.e. the option with highest NPV is to be chosen.
If the other option, however, gives a singular, more immediate return then the opportunity cost can be added to the C0 total costs incurred. What this does is it changes the decision-making approach and you choose the option that has an NPV greater than 0 instead of the one that has the highest NPV.
Apart from the opportunity cost there are 4 other commonly useful elements you should ideally take into consideration when making business decisions and mitigating business costs:-
1. Cost: Evaluate the cost of making a decision and/or the expenses you will incur as a consequence of that decision.
2. Time: Time is money. Even if there are two options where one saves you money and the other time, take into consideration which is more important to your organization in that context.
3. Utility: Utility or value optimization is the crux of decision-making. When making a business decision consider the utility that the chosen option will have and the value it will create for your business in comparison to the option forgone.
4. Effort: The effort required to perform the task you’ve chosen should also play a role. Your focus should be on minimizing the effort required by the option you’ve chosen.
These factors are also often mutually interdependent. When making business decisions your guiding principle should look something like this - maximize utility and value created while minimizing the cost incurred, time spent and effort required.
All business decisions and choices you make must be informed and driven by methodical considerations of all moving parts. While the number of moving parts and variables in decision-making might be difficult to put a finger on, by calculating opportunity costs of business decisions you can come pretty close.
Calculating opportunity cost in business is important not only because it endorses sound decision-making but also because it helps protect investments and resources. It also helps mitigate risk and determines how you should be designing your capital structure, essentially helping how you do budgeting.
Related read: Types of expense categories to include while budgeting
Any money that you’ve spent and will not be able to recover falls under the category of sunk cost. On the other hand, the money or benefits that could be earned or lost when choosing between options is referred to as the opportunity cost.
For instance, if you’ve spent $100 on upgrading your most important manufacturing equipment then $100 is your sunk cost. If instead, you spent the same amount on marketing you realize you could have gained 20 new customers. The difference in revenue generated between these two scenarios will give you your opportunity cost.