Economic theory refutes the notion of "having it all" when resources are limited. The simple truth is, no matter how advantageous the outcome of any business decision may be, rejection of competing options — including doing nothing — implies other benefits were sacrificed. The value of those other benefits is called opportunity cost, and its assessment plays an important part in the overall decision-making process.
What Is Opportunity Cost?
The opportunity cost is the value the company forgoes when choosing one option over another, whether the loss is monetary or use of time (productivity) or energy (efficiency). When a company decides to allocate resources to one activity or area, it also decides not to pursue a competing activity. Opportunity cost is an especially important calculation for smaller businesses, which by definition have more limited resources and funds than their larger counterparts. It involves weighing which decision will potentially provide the greatest return on their investments and with the least risk, helping managers make better decisions.
- Opportunity cost is money or benefits lost by not selecting a particular option during the decision-making process.
- Opportunity cost is composed of a business's explicit and implicit costs.
- Opportunity cost helps businesses understand how one decision over another may affect profitability.
Opportunity Cost Explained
Opportunity cost is incurred when a business chooses one option over another. For example, consider an ecommerce business that to date has shipped its products directly to customers. Now sales volume has surged to the point where the time it takes to handle shipping has become unmanageable. As a result, the company is seriously considering outsourcing the function to a third-party logistics provider. Granted, the latter will cost it more, but the time saved also has value by eliminating employee involvement. Instead, these workers can focus on new product development, which, in the long run, can lead to new revenue streams.
How to Calculate Opportunity Cost
Opportunity cost is calculated as part of the cost-benefit analysis (CBA) process businesses use to evaluate competing priorities and support decision making. The most time-consuming aspect of calculating opportunity cost will be gathering the various inputs needed to gauge potential returns if they don't use software to record their financials. But once that information is in hand, the calculation is just a matter of subtraction:
Opportunity cost = return on option not chosen –return on option chosen
As a simple example, if our previously mentioned growing ecommerce business is deciding whether to lease a nearby 5,000-square-foot warehouse for $6,000 per month vs. the same size facility 20 miles away for $5,000 per month, the opportunity cost for selecting the more expensive option would be $1,000 per month. And that's just for the space alone. But opportunity costs also come in the form of the time spent commuting to the farther location, money spent on gasoline and vehicle wear and tear. Over time, the seemingly more expensive decision may prove to be less expensive after all.
What Opportunity Cost Tells Businesses
Every business decision represents benefits gained and lost. By understanding what is given up by not choosing a particular option, a business can better compare the value — i.e., the opportunity cost — of one decision over the other.
For example, the decision to purchase a new construction vehicle can be viewed as a comparison between what the business will gain by buying one — such as the ability to begin a new project while another is ongoing — versus what it will cost it by not buying one, such as the inability to take on that new project and forgoing its resulting profit. Opportunity cost informs the business about what it will miss out on by not selecting an option or, conversely, the opportunity realized from its selection.
Weighing opportunity cost
Opportunity cost is the sum of two specific types of costs: explicit and implicit, the former being more easily calculated than the latter.
Explicit costs, also referred to as accounting costs and explicit expenses, are typical business expenses a company incurs and records in its general ledger. They have an actual, tangible dollar amount and directly affect cash flow and profitability. Examples of explicit costs include typical business expenses that can be quickly obtained from an enterprise resource planning (ERP) system that centralizes the data, such as rent, payroll, equipment, utilities and advertising, from different parts of the business.
Unlike explicit costs, implicit costs typically don't have a fixed monetary value that a company can track. Rather, they reflect the indirect, intangible costs of using already owned assets and resources. Implicit costs — also referred to as implied, imputed or notional costs — aren't recorded for accounting purposes and reflect a loss in income, not profit. For example, the time spent by a procurement team member to research and compare different construction vehicles is an implicit cost; the explicit cost is the vehicle's purchase price.
Implicit costs are considered an opportunity cost, in and of themselves. The time spent by the procurement employee tasked with assessing construction vehicles represents a loss of what that person could have been working on otherwise.
Opportunity Cost and Profits
At the end of the day, opportunity cost can be framed as profit made or missed as the result of a business decision. Just as there are two types of costs, there are also two types of profit: accounting and economic.
Accounting profit is a business's net income, also known as the bottom line because it can be found at the end of the income statement. Accounting profit is calculated by subtracting the business's total explicit costs from total revenue, revealing how well the company is performing financially. Investors and lenders also look at accounting profit to help determine whether they want to work with the business.
Economic profit equals total revenue minus explicit and implicit costs; don't be surprised if it's very different than accounting profit. Also, keep in mind that economic profit is theoretical in nature because it accounts for opportunity costs, meaning the value of actions not taken. Economic profit reflects how efficiently a business is operating and allocating its resources.
Opportunity Cost Examples
There are as many examples of opportunity costs as there are decisions made. Even the decision not to make a decision is a decision. But every decision has a value associated with the path not taken. Here are some examples of opportunity cost:
- A company decides to spend $50,000 to launch a new product. The opportunity cost is the value of the $50,000 that can't be spent elsewhere.
- An employee is contemplating going back to school full time to earn a master's degree. The opportunity cost of this decision is the salary they won't make for two years.
- An investor is debating whether to sell $8,000 worth of shares in a company. The stock price is expected to increase in three months, but they need the money now for a down payment to lease office space. In this example, the opportunity cost can't be determined until three months later, when the difference between the new stock price can be subtracted from its current price.
- A company notices sales have slowed down for a hot-selling product; it still has $10,000 worth left in inventory. Its annual carrying cost for holding the inventory is 20% of the products' value, or $2,000. The company is considering discounting the products 15%, losing out on $1,500 worth of revenue in an effort to sell the rest, clear inventory and save on carrying costs.
- A business has a $500,000 surplus that it can use to upgrade its manufacturing plant or invest in the stock market. If it expects the renovations to generate a 9% return in the first year and the investment to generate 12% for the same time period, then the opportunity cost of going with the first option is 3%. Investing in stock would be the better choice because the return is expected to be much higher.
Calculate Opportunity Cost With Accounting Software
Every day, business leaders make decisions that can impact their companies' profitability. Opportunity cost is the value of the eliminated choice, and it's an important consideration during any decision-making process. Calculating opportunity cost requires access to real-time transactional and financial data that can be found in a comprehensive software package like NetSuite Cloud Accounting Software. The cloud-based solution streamlines the data collection process, enabling decision-makers to estimate returns on various scenarios more quickly than having to manually track down needed information. NetSuite's accounting software also provides businesses with a comprehensive view of their cash flow and financial performance, and automates time-consuming accounting tasks, such as updating journal entries, account reconciliations, accounts payables and receivables processing and closing the books.
As a business grows, the need for automated software to manage other operational activities, such as supply chain, inventory and order management, grows as well. NetSuite ERP integrates a company's separate functionalities in a single database, providing a holistic view and leading to more-informed decision-making that positively impacts profitability.
Successful businesses rely on data to help decide where to allocate their finite resources, be it capital, time or energy. Part of their due diligence is factoring in opportunity cost — an economics term that describes the value and benefits lost by not choosing a particular option. By calculating opportunity cost, which adds together both implicit and explicit costs, businesses can best determine the path to higher returns and, in turn, greater profitability.
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Opportunity Cost FAQs
What is opportunity cost in business and example?
An opportunity cost is the value of the option not taken when a business makes a decision. For example, if the business is deciding whether to purchase two new tractors, the opportunity cost of not doing so would be the potential revenue and profitability lost by not being able to take on another project.
What has an opportunity cost?
Any decision a company is weighing has an opportunity cost associated with it. Understanding the opportunity cost of not choosing one option or the other can help the company make a more informed decision.
What is the difference between opportunity cost and sunk cost?
Sunk cost is money a business has already spent on something. Opportunity cost is the potential return lost by choosing one option instead of another.
Why does opportunity cost matter?
Opportunity cost helps businesses better understand the many factors that can impact their profitability. That includes the decision not to select an alternative option.
When should businesses not use opportunity cost?
At the heart of any decision lie two or more choices. Therefore, it is always wise to calculate opportunity cost before making a decision.