What is opportunity cost?
Opportunity cost is the benefit that your business will miss out on when you turn down one investment alternative in favor of another. When you choose between two or more options for the future of your business, you can weigh the different opportunity costs to make sure you are choosing the right possibility.
Defining opportunity cost is sometimes limited to finances, but it can also include time, person-hours, retail space, and any other limited resource. You might already have created a budget for how much capital you can spend on a given project, but other resources are sometimes more difficult to measure.
You won’t be able to take advantage of every opportunity that comes your way; because your business has limited funding and resources, you’ll have to pass over some possibilities. Evaluating the opportunity cost is one way to decide which choices are the best fit for your business.
Types of opportunity cost
There are different types of opportunity cost. The two most common are explicit costs and implicit cost.
Explicit costs account for things that have a direct financial price, such as the amount you would pay for a new marketing campaign, or how much it would cost to rent heavy machinery for a project.
Implicit costs are not associated with a dollar amount, but represent the value of your lost resources that could have earned income in other ways. For example, if you spend two weeks of your time working on a project with little or no return, you could have instead spent that time on a more lucrative pursuit.
The opportunity cost formula
Before you make decisions about which investments you’ll choose to pursue in your business, you’ll want to assess the potential benefits. You can do this by calculating the opportunity cost with this formula:
(Expected return on choice X) – (Expected return on choice Y) = Opportunity cost
When an opportunity cost is negative, that means you are losing more than you are gaining from a given possibility. But when an opportunity cost is positive, you’re gaining more than you are losing, which usually puts your business on the right track.
Sometimes an opportunity cost will not be exact, and that’s okay. You can still assess the overall cost based on estimates and likely possibilities, even though you can’t predict the future.
Being more familiar with business forecasting can help you prepare for different possible financial situations, so you’ll be ready for different costs that may arise in the coming years.
This same arithmetic is also useful for determining the opportunity cost of various investment options you have turned down in the past, so you can learn how to make smarter financial decisions moving forward.
Examples of opportunity cost
Every business leader has to weigh the pros and cons of different investment options. The simplest way to demonstrate this is with a stock investment.
Let’s say you have $1,000, and you are choosing whether to invest in an index fund or a tech stock. If the index fund has a projected return of $70 over the course of a year, while the tech stock has a projected return of $110 over the same amount of time, the difference between those two amounts—$40 a year—is the opportunity cost of choosing the index fund.
This doesn’t necessarily mean that the tech stock is going to be the right choice, because you still have to consider other factors, such as the risk level of these different possibilities. But using a formula to know the opportunity cost is one factor that can help you make the decision.
Calculating opportunity cost can become more complicated. Let’s say you own a company that sells scented candles, but so far your business has only operated online. Now that you have enough capital to start thinking bigger, you are considering opening a retail space in your city.
The opportunity cost formula for this is more complicated. You can easily compare the costs of renting or buying a storefront, but you also have to consider the opportunity cost of the time you will have to spend finding the right space in the perfect part of town, as well as hiring new employees to work the sales floor. You might also consider your business budget for the expense of shipping a great deal of your inventory to a new location on a regular basis.
All of this must be weighed against the other alternatives for your capital and your time: maybe you could instead use it to buy newer, more efficient candle-making equipment, or start adding scented room sprays to your lineup.
Every choice you make has a cost when compared to other choices, and it might not always be obvious.
Why does opportunity cost matter?
While opportunity costs are not necessarily something that will ever show up on your financial records, they are an important concept to understand as you grow your business. Assessing opportunity cost is one way to quantify the value of various decisions, both in your business and in your personal finances.
Opportunity costs can’t be calculated without a greater understanding of how you want to allocate funds in your business. BILL can assist with smart budgeting software that helps you determine your financial goals and never go over budget again.