How does Opportunity Cost work in a business?
The opportunity cost in business can be understood in terms of potential gains or profits an entrepreneur forgoes by making one choice over another. Due to the increasing possibilities to spend, save, or invest in a business, entrepreneurs need a precise way to compare their options to stay within their budgets. This is where analyzing the opportunity cost in business comes into play. It allows for the quantification of the advantages and drawbacks of each choice, resulting in more lucrative overall decision-making. This article explains different types of opportunity costs, the importance of opportunity costs, and calculating the opportunity cost in business with the opportunity cost formula. We will also discuss some opportunity cost examples for better understanding.
Opportunity cost in business
Resources are sometimes restricted or limited in a new business. Decisions for following an action plan or making one choice could limit the capacity of a business to follow a different path of action. The opportunity cost in business calculates the price of a choice when the next best option is given up or surrendered. Let’s examine it in further depth.
What is the opportunity cost?
When deciding between two options, opportunity cost is the expense associated with not choosing a specific option because of the loss of potential advantages it could have brought. The expense of not taking advantage of an option is known as its opportunity cost. You incur costs by selecting Alternative A over Alternative B, whether those costs be monetary, time-based, or otherwise. By considering the possibilities lost when selecting one investment over another, businesses and individuals can make more informed decisions.
How does opportunity cost work in a business?
Let us understand how the opportunity cost in business works with an example. Say a business is contemplating purchasing bond X from the money it could get by selling bond Y. The comparison of opportunity costs is shown below:
| Bond X | Bond Y |
|---|---|
| The value in the future could rise | The value in the future could rise |
| The value in the future could drop | The value in the future could drop |
In such a situation, the business owner has to consider the selling price of bond Y and buying price of Bond X. Let’s assume, Bond Y would sell for $12,000 to purchase Bond X for $23,000. Since Bond X would require additional spending of $11,000, you need to consider the interest rate. One can still make more money by investing more money at a lower interest rate. However, to increase the value of bond X, the business must need to earn more than $11,000.
The opportunity cost is the interest you keep getting from bond Y and the $11,000 you lost on bond X. However, if the business goes ahead with the transaction, they are expecting it to get it back with Bond X and make more money in the future.
How to calculate opportunity cost?
The opportunity cost formula is useful in estimating the effect of an impending action or can be used to calculate the benefits or losses of previous decisions. It is simply the difference between the potential returns of each choice.
You can calculate the difference between the anticipated returns for two distinct choices using the opportunity cost formula:
Where:
FO = Return on best forgone option
CO = Return on chosen option
There are certain barriers when determining opportunity cost. The formula itself is simple; however, the inputs aren’t always. Non-monetary elements like risk, time, expertise, or effort are difficult to describe.
The more accurate numbers you can include in your prediction, such as market-rate compensation, the typical rate of return, the lifetime value of customers, and competition financials, the better.
Types of opportunity cost
There are two types of opportunity cost based on the nature of the payments as discussed below:
- Explicit cost – Explicit cost is a type of opportunity cost that can be measured by the direct expenses incurred by choosing an option. It is carried out either via a monetary transaction or a material shift of resources. For instance, paying staff or firm running expenses. They are recognizable out-of-pocket expenses incurred by a company.
- Implicit cost – Implicit costs do not involve monetary exchange. They don’t affect you directly; rather, they represent a missed chance to use your resources to make money. These expenses often go unnoticed and are concealed from view. For instance, a startup company owner decides to sacrifice taking out his salary to increase the profitability of his business.
Examples of opportunity cost
Here are four examples of opportunity cost in business to allow you a better understanding of the concept:
- Investors dilemma – When an investor chooses to buy company shares with a business giving higher returns over a stable business, the opportunity cost is the difference in the return rate and the payout’s safety.
- Work leisure – A business owner decides to maintain a strict boundary between work and leisure. They decide to take the weekends completely off to tend to their mental health and spend time with their loved ones. Here, the opportunity cost is the productivity increase from working two days on the weekend that the business owner forgoes.
- Investment for future consumption – When a business invests in purchasing economic resources to support the going green campaign and reduces the current production at a cheaper rate, the opportunity cost is the sale of more products at a lower price.
- Govt spending priorities – If the government were to invest an additional $15 billion in education, it could mean $15 billion less money for affordable housing and medical care for the public. The opportunity cost here is $15 billion and the number of people the government could aid by choosing affordable housing or medical aid for funding.
How does opportunity cost work in the capital structure?
The capital structure of a company is heavily influenced by a determination of the opportunity cost. To reduce the opportunity cost in business, a firm must weigh the monetary and nonmonetary pros and drawbacks of each potential course of action. It is important to consider the risks and volatility of returns to reach an accurate number.
How does opportunity cost differ from sunk and marginal cost?
A sunk cost is the amount of money that is already spent. It is a matter of the past. On the other hand, the opportunity cost is the return on investment that would have been made if the money had been invested elsewhere. It can be a matter of the future.
For example, the initial expenditure to buy a costly piece of heavy equipment can be a sunk cost since even if it is repaid over time, the money spent on the acquisition will never be recovered.
On the other hand, opportunity cost is calculated when deciding between investing in a piece of heavy equipment with a 6% ROI and one with a 4% ROI. Buying the cheaper one with 4% ROI, the opportunity cost returns that could have been earned with the equipment with 6% ROI.
Unless there are particular uncertain outcomes relating to the money in question, the opportunity cost in business does not take into account any sunk costs that have already been committed.
Uses of opportunity cost at an economic and business level
Businesses calculate opportunity cost to get insights into the following metric:
- Accounting profit – The primary function of quarterly and yearly financial statements is to report on the financial health of a business. Thus, accounting profits focus on explicit opportunity costs: things that can be seen and counted, such as salaries and rent payments. Total profit is calculated with the difference between income and explicit costs.
- Economic profit – Economic profits are calculated by factoring in explicit and implicit opportunity costs to help in decision-making in the company. A company can determine whether a certain choice and subsequent distribution of resources are efficient or if adjustments need to be made. The potential for monetary gain is not always indicative of the success of a particular business choice. It represents whether or not a certain choice is wise in light of the alternative.
- Comparative advantage – Having a comparative advantage means that a country, organization, or person can create a product or provide a service at a lower opportunity cost than its competition. For example, a firm has a comparative advantage if it expands less of a given resource than a competitor in the same industry to produce the same output.
- Absolute advantage – Absolute advantage is used to describe a party’s ability to utilize its resources to create products and services more effectively than its competitors, regardless of the opportunity costs that party may incur. If one corporation consumes more of a given resource yet generates more output per unit of labor used than its rival, the former has an absolute advantage over the latter. Comparative advantage relates to how little is given up in terms of opportunity cost, while absolute advantage refers to how well resources are employed.
- Government regulations – When passing laws, governments must also take opportunity cost into account. One can comprehend the magnitude of the implicit cost that the government must take into account by considering the example of investing in education above affordable housing and healthcare described above. The homeless epidemic in America has all the makings of a serious emergency. The policies that prevented the United States from developing adequate homes are often considered the root causes of the present homelessness issue. According to the National Low Income Housing Coalition, seven million tenants with very low incomes cannot find affordable housing. The government must consider all these statistics when calculating the opportunity cost of decisions they make.
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