The funny thing about the term “opportunity cost” is that you’re not sure whether it’s a good thing or not.
You are given an opportunity, which is usually a good thing.
But there’s a cost about which you’re not quite sure.
Thankfully, the term is not a linguistic one that can be parsed in different ways — it has to do with economics.
The opportunity cost, or alternative cost, usually refers to all the things one gives up when making a choice.
It’s essentially all the potential options you don’t take, and a nice way of saying “you can’t have it all” or “FOMO.”
But why is this so important to economics and business?
Is there something beyond just missing out?
This post looks into opportunity costs from a business standpoint, and explains how to calculate it when making a decision.
- Definition of Opportunity Cost
- What’s Included in Opportunity Cost?
- How to Calculate Opportunity Cost
- Where Opportunity Costs Fall Short
- Why Is Opportunity Cost Important?
- Taking the Opportunity
Definition of Opportunity Cost
The Oxford University Press defines opportunity cost as “the loss of other alternatives when one alternative is chosen.”
This loss comes in many different forms, including money, time, and even other opportunities.
When applied to decision-making, opportunity cost is usually the answer to two pressing questions — “What am I sacrificing?” and “What am I gaining?”
Economists, on the other hand, have a slightly different definition.
According to The Library of Economics and Liberty, opportunity cost is “the value of the next-highest-valued alternative use of that resource.
If, for example, you spend time and money going to a movie, you cannot spend that time at home reading a book, and you can’t spend the money on something else.
If your next-best alternative to seeing the movie is reading the book, then the opportunity cost of seeing the movie is the money spent plus the pleasure you forgo by not reading the book.”
In other words, it’s the value of the next best alternative — the value you could have had if you didn’t already make your first choice.
This takes a slightly different perspective, considering what you just missed out on by choosing something else, and looking at opportunity cost as essentially a trade-off.
The tricky thing is that no matter what definition you stick to, opportunity costs are nearly impossible to pin down and quantify.
What are the potential opportunities that you may have missed?
How do you put that to paper?
What’s Included in Opportunity Cost?
The “cost” in opportunity cost doesn’t necessarily mean money.
It can be time, satisfaction, or any other useful benefits that are no longer available.
Opportunity costs are usually divided into two — explicit costs and implicit costs.
Explicit opportunity costs are those that directly involve money.
Say you spend $15 on a sandwich for lunch — that’s $15 that you didn’t spend on a salad bowl or sushi roll.
Implicit opportunity costs, also called implied costs, are not reflected monetarily, but rather implied.
These are more of the “could have” variety.
For example, if you have a second computer you’re not using, your opportunity cost is the income you could have generated if you sold it instead of leaving it in your closet.
How to Calculate Opportunity Cost
Thankfully, as with most business finances, there’s a formula.
To calculate the opportunity cost from a purely financial standpoint (if you’re only considering explicit costs), simply subtract the expected return of the chosen option from the expected return of the foregone option.
In a formula, this is:
Opportunity cost = FO (return on best forgone option) – CO (return on chosen option)
Say you’re considering the opportunity cost of selling your shares in a company at $10,000 now versus selling in six month’s time, when the stock is valued to be $15,000.
If you decide to sell now, your opportunity cost is $5,000.
(This is FO, which amounts to $15,000, minus CO, which is $10,000.)
Just as there are other ways of looking at opportunity costs, there are also other formulas to calculate for it.
A second opportunity cost formula uses ratios, arriving at an opportunity cost by dividing what you look to sacrifice by what look to you gain.
The formula is:
Opportunity Cost = What You Sacrifice ÷ What You Gain
For instance, you’ve been thinking of leaving your full-time job as a human resources associate, where you get paid $20 per hour, to work at your dream job as a barista for $10 an hour.
Should you make the jump, your opportunity costs in this decision is $2, meaning, for dollar earned as a barista, you’re sacrificing the additional $2 you would’ve earned if you stayed a human resources associate.
Where Opportunity Costs Fall Short
Of course, no matter what formula you use, what you choose or gain isn’t just tallied up in numbers.
There’s really no accounting for specific factors within the decision, unexpected changes in the future, and, something more important, personal value and benefit.
A lot of the foregone or sacrificed opportunities also can’t really be nailed down in numbers.
Oftentimes, they’re just assumptions and may limit the whole point of calculating opportunity costs altogether.
Especially in the case of financial statements, it requires a lot of other business knowledge and high-level analysis to properly understand the opportunity cost involved in making a decision.
That being said, it may be all to easy to get caught up in the calculations, simply relying on these to make decisions that you know in your gut you won’t be happy with.
Calculating opportunity costs does not make your decision for you.
It helps you make your decision — the decision you were thinking of already — in a more informed manner.
Why Is Opportunity Cost Important?
As a key concept in economics and finance, opportunity costs do help an entity allocate its limited resources.
What would be the best use of their time, energy, and manpower?
In cases where efficiency and cost are big concerns, knowing the opportunity cost of major decisions is extremely helpful.
Example of Opportunity Cost in Business Investments
Opportunity costs are also useful when choosing between potential business investments, and which will yield the greatest return.
For instance, a freelancer or small business owner may not be sure whether they should invest their extra funds in some new equipment or in a bank security.
By calculating the opportunity cost that comes with each decision — in this case, how much more revenue can be generated from the new equipment versus how much interest they’ll earn from a bank security — they will know just how much more (or less) each decision will cost.
Example of Opportunity Cost in Business Economics
Another scenario where a business may find opportunity costs especially useful is in allocating their manpower and resources.
Say a manufacturing company produces both chairs and tables and employs a total of 25 people — those people are tasked to produce either chairs or tables.
Now, assigning more people to produce chairs means that less people are producing tables.
Where should they be assigned to best benefit the business?
This depends on a number of factors, particularly which product is more in demand and which product generates more profit.
Decisions like these are a tricky balance that greatly affects not just revenue, but the success of a business in the long run.
Example of Opportunity Cost in Personal Matters
While applying a formula may seem a bit exacting for most small personal decisions (i.e., what to do this weekend), it can greatly help when making larger life choices (i.e., enrolling in a night class).
Using the night class example, say you’ve been wanting to learn take a short coding course to add to your skill set, and possibly negotiate for a salary increase.
On the other hand, you could also just take on more hours or another part-time job.
How would your three hours in the evening be best spent?
Calculating the opportunity costs for this choice — what you can stand to gain with both alternatives — may be what you need to know to make your final decision.
Taking the Opportunity
Calculating opportunity costs doesn’t seem like something many people do when making decisions.
For the most part, choices are made by other factors — ease, location, habit, gut feel, etc.
And while all these should also be taken into consideration, especially for weightier decisions, being able to know the opportunity cost is a good tool to have when you need it.