Opportunity cost
Opportunity costs are what investors and investing businesses used to describe the gains or benefits that those investors and businesses lose out when they choose one opportunity over the other. The concept is part of microeconomic theory which focuses on the decision-making that comes from working with scare resources.
Put simply, the opportunity cost represents the benefit that might have been gained if the alternative opportunity had been taken. The opportunity cost is the cost the business misses out on for these missed benefits.
Investors and businesses use opportunity costs to establish what the best course of action, or the best decision, is to make. Each opportunity cost gives an idea of what might be missed out on by pursuing one option, so this is weighed against the potential gains to indicate the best route forward.
Opportunity costs, by their own nature, are sometimes difficult to discern in the decision-making process, but identifying them is integral to making the right choice.
Key takeaways from this section:
- Opportunity cost is the value of the next best alternative to the choice a business can make.
- Opportunity cost is worked out by subtracting the returns you’ll make with the choice you’ve made, from the returns you could have made from the next best alternative.
- Opportunity cost is one of the key metrics a business will look at when making any kind of business decision, from taking on new liabilities to making new investments.
Understanding opportunity cost
The initial way of working out opportunity cost is to use a fairly straightforward formula, where you subtract the returns you’ll make with the option you choose, from the returns you would have made with the best option of the ones you didn’t take. This will give you the opportunity cost of the second best option.
Say for example you’re deciding on what to eat on a Friday night. You could either order in a takeaway or head out to a restaurant - the restaurant will be pricier and you’ll have take the time to get dressed and head out, but it’ll probably be more enjoyable.
If you choose to go to the restaurant, the opportunity cost of doing so will be the extra money you’ll spend dining in the restaurant, and the extra time and effort it’ll take you to leave the house.
Within economics, the opportunity cost of taking certain decisions over others can have enormous ramifications across a business – which is why strategists, economists and accountants all take a lot of care to research the opportunity cost of the option they intend to go for before making any moves.
Opportunity costs comparison
Most businesses will always look to guarantee some sort of return from their decisions. This doesn’t necessarily have to be monetary; certain decisions taken by strategists will result in better efficiency, fewer wasted resources and minimised risks – though this will all come back to the financial side of things in the long run.
Consequently, the first thing they look at is the rate of return – that is to say, how much they stand to gain independent of any other options available. The second thing the should, and do, look at is the opportunity cost.
Businesses include an opportunity cost evaluation with every investment they make, every bit of debt they accrue and every move they take when it comes to their business operations.
Opportunity cost FAQs
How do you determine opportunity cost?
Before opportunity cost can be worked out, you’ll need to forecast the potential returns of both the option you intend to take, and the returns of option that you consider to be the second best alternative.
Once you have those two returns established, you’ll need to compare them, and to subtract the returns on your chosen option from the returns on the alternative. The result, as a monetary figure or a percentage point, will be the opportunity cost of the decision you have taken.
What is an explicit opportunity cost?
An explicit opportunity cost is the direct and explicit consequences and costs of the choice taken by the business. That means they are obvious costs that your business will need to pay – either assets or cash normally. Explicit opportunity costs can be easily counted in money and identified as costs, as can their transactions.
What is an implicit opportunity cost?
Implicit opportunity costs are costs that aren’t immediately obvious when evaluating the opportunity cost of a decision. These are less tangible than explicit opportunity costs which can often be counted in currency or in individual resources.
Implicit opportunity costs include things like the time it takes to complete a project, or the human input a project requires. They don’t normally have a price attributed to them when it comes to evaluating a decision, though they can have a significant impact on a company’s financial wellbeing.
What is the difference between opportunity cost and sunk cost?
Simply put, sunk cost is money that has already been invested and cannot be reclaimed. This money or resource has already been spent and can only be retrieved by liquidating the purchase or investment.
By contrast, opportunity cost deals with hypothetical costs – the returns of the first best alternative is yet to be spent. Once the opportunity cost is analysed and the decision made, then the money will be considered as sunk cost.
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