What is Opportunity Cost and Why is it Important in Your Business?

Opportunity cost isn’t something many business owner’s discuss as frequently as other costs, but they impact the outcomes of individuals and businesses every single day. This is primarily because opportunity costs don’t show up on your financial statements. Don’t let out of sight be out of mind, however, as taking these costs into account when making decisions for your small business can make a big difference to your bottom line. What does opportunity cost mean? Whenever a business (or individual) chooses one investment or course of action, they are also rejecting a range of alternative options. Those alternatives may have also resulted in a benefit for the business. The foregone potential benefit a business doesn't get is the cost of the missed opportunity. Factoring in this cost is a good practice for any entrepreneur because it encourages them to carefully consider the range of options available to them whenever they make a decision for their business. A small business owner can then choose the option that minimizes their opportunity costs. Examples of opportunity cost The concept of opportunity cost can best be illustrated through example, so let's imagine a company that manufactures bicycle parts. They have $100,000 available to invest, and they could use this money to update their equipment. The updated equipment would enable them to increase the number of products they produce, and they anticipate the increased output would help them increase their net profits by $110,000 this year. However, they also have the opportunity to invest in the stock market, and they expect they could generate a rate of return of 15 per cent in one year on their investment. If they choose to invest in equipment, they can have a profit of $10,000 by the end of the year, and if their projection for their stock market investment is correct, they can have a profit of $15,000. The opportunity cost of choosing to upgrade the equipment is the difference between their actual return and the return they could have had if they chose the other option. In this example, it seems it would be better to invest that money in the stock market rather than into the equipment. However, investing in equipment is a far less risky choice than investing in the stock market. They may project returns of 15%, and in reality, end up with only 5%, or even a negative return. Calculating opportunity cost is rarely precise, and the risk tolerance of the decision-maker will affect their calculation. If this bicycle part manufacturer is risk-averse, investing in equipment may be the better choice after all. We often consider the explicit costs of our decisions, but it's less common to do an opportunity cost analysis of the choices we make. While we usually can't predict opportunity cost perfectly, it is still very useful to make educated predictions with the information available. This principle applies to all kinds of business decisions, such as whether to hire an employee or work with a freelancer, whether to digitize corporate documents such as minute books, whether to rent an office or set up a home office. How to calculate opportunity cost To calculate opportunity cost, you only need two variables: FO = the return on the best of your foregone options CO = the return on the current option Opportunity Cost = FO - CO Using the example above, the opportunity cost of investing in equipment if the anticipated return on investing in the stock market is 15% is as follows: Opportunity Cost = 15,000 - 10,000 = $5000. This means that the opportunity cost of investing in equipment is the extra $5000 that could have been generated by investing in the stock market. The opportunity cost of investing in the stock market is: Opportunity Cost = 10,000 - 15,000 = -$5000. In this case, it seems the next-best alternative, FO, wasn't as good as the current option, CO, meaning the best possible choice was made in terms of opportunity cost. Other costs to consider Opportunity costs aren’t the only costs a small business owner needs to consider. Here are two other costs to factor into your decision making. Opportunity cost vs. sunk cost If you're thinking of starting a company or you're already running one, you've probably come across the term "sunk cost." If so, you may wonder if this cost is any different from opportunity cost. Opportunity cost refers to the potential future returns of an investment that are forfeited because the investment was made elsewhere. Sunk cost may sound similar, but it refers to money already spent in the past that cannot be recovered. For example, the existing equipment that the bicycle part manufacturer in our example already has would be considered a sunk cost. Since sunk costs have already been spent and do not change based on decisions a firm makes about the future, typically they aren’t considered in deciding about the future the way opportunity costs are. Opportunity cost vs. trade-off A trade-off doesn't refer to a quantifiable cost the way opportunity cost does. A trade-off describes the course of action given up in order to move forward with a different action. In our example, investing in equipment is the trade-off for investing in the stock market. The opportunity cost is the quantifiable cost of choosing one action and forgoing another. Choosing how to invest your resources As a business owner, you face financial decisions regularly. Whether you're bootstrapping your business or you've gotten funding for your business some other way, you probably want to make sure your money goes as far as possible to help your business grow. Making your purchases and investment decisions by calculating a reasonable opportunity cost for all the alternatives available to you is a good practice that can minimize your losses and improve the financial health of your sole proprietorship or corporation. To properly evaluate opportunity costs, the costs and benefits of every option available must be considered and weighed against the others. This will help you maximize your return on investment each time you're faced with an important decision about how to invest your business budget. Factors to consider when investing in your business It's important to recognize that we rarely have perfect information and foresight in terms of the cost of a lost opportunity or the exact return on a given investment. However, you can still think through the economic opportunity cost of your investments in order to see past the direct cost and consider if there may be a better way to spend your money. Another important factor to consider is the risk associated with each option you're considering. An investment with a lower rate of return may still be preferable to other investment choices with potentially high annual interest rates that aren't guaranteed. You may be more open to risk when investing $5,000 in some aspect of your business, and less so when you're investing a larger sum like $20,000. By adding opportunity cost analysis to your decision-making, you can feel confident you're making a more informed choice beyond looking at the sticker price of each investment. The bottom line is understanding opportunity cost is a great way to make your money go further.