How to Calculate The Opportunity Cost of a Decision
Opportunity Cost Definition
Opportunity cost is the value of the best alternative that was given up when a decision was made.
In other words, it’s what you could have gained if you had chosen a different course of action.
CIMA’s official terminology to define an opportunity cost is:
“The value of the benefit sacrificed when one course of action is chosen in preference to an alternative. The opportunity cost is represented by the forgone potential benefit from the best rejected course of action”
Learning how to calculate the opportunity cost of a decision is a critical concept in economics, finance, and decision-making, as it helps individuals and businesses to make informed choices by evaluating the potential costs and benefits of their options.
Opportunity cost can be a useful tool for decision making because it helps to identify hidden costs and outcomes that may not be immediately obvious.
Different Types of Opportunity Costs
There are two types of opportunity costs: explicit and implicit.
Explicit opportunity costs are the direct costs associated with a decision.
For example, if a business chooses to invest in a project, the explicit opportunity cost would be the cost of the investment.
Implicit opportunity costs are the indirect costs that are not easily quantifiable.
For example, the cost of the time and effort spent on trying to improve the process of a business, instead of doing something else would be an implicit opportunity cost.
It is important to consider both explicit and implicit opportunity costs when making decisions to ensure that you are fully aware of the potential costs and benefits of your options.
Formula for Calculating Opportunity Cost
Calculating opportunity cost is relatively simple using the formula:
Opportunity cost = (Value of next best alternative) – (Value of current option)
To use this formula, you need to determine the return or benefit of the best alternative option and the return or benefit of the chosen option. The difference between these two represents the opportunity cost.
For example, a business is looking to invest in a new project and are considering two options:
Option A is to invest in a project that is expected to generate a return of 10%
Option B is to invest in a project that is expected to generate a return of 5%.
If Option A is chosen, the opportunity cost is the return on Option B that you are giving up.
Using the formula, the opportunity cost would be calculated as:
Opportunity Cost = 5% (Return on Option B) – 10% (Return on Option A)
Opportunity Cost = -5%
In this case, the negative result indicates that by choosing Option A, you are giving up the opportunity to earn 5% on Option B.
Examples of Opportunity Costs
To further understand opportunity cost, let’s look at a number of examples:
- A business is looking to build and market a new product to their existing lineup. This would require an initial investment of £60,000. The opportunity cost is the potential value of that cash being spent elsewhere, or kept in the bank’s reserves for the future.
- A manufacturing company receives two unusually large orders, but only has the capacity to fulfill one of those orders. The first order would generate a profit of £100,000, and the second order would generate a profit of £125,000. The business decides to maximise profits, and selects the second order to produce a £125,000 profit. The opportunity cost of this decision is £100,000, as the business foregoes a £100,000 profit, in favour of a £125,000 profit.
- A business owns a piece of land in a prime location. If the business chooses to use the land for their own purposes, the opportunity cost is the potential income they could receive by renting the land to another business or developer. In other words, the opportunity cost of using the land for their own purposes is the foregone income from leasing it out to a third party.
- A business is looking to spend £50,000 on a new marketing campaign. The two options available to them is to either invest in social media advertising or invest in billboard advertising. Social media advertising is estimated to yield a 5% increase in sales, while billboard advertising is estimated to yield a 7% increase in sales. The opportunity cost is the 2% increase in sales that could have been achieved if the business had chosen to invest in billboard advertising instead of social media advertising.
- A company has a surplus of cash, and has the option to either give it to shareholders as a dividend or invest in new projects which could increase revenue. By choosing to invest in a new project, the company is foregoing the opportunity to pay dividends to its shareholders. The opportunity cost of not paying dividends is the potential loss of income or benefits that the shareholders could have received if the company had chosen to pay dividends instead of investing in the new project.
- A business is facing a dilemma between specialisation and diversification when deciding to produce a single product or offer a range of products.
On one hand, specialisation can lead to higher efficiency and focus, while diversification can mitigate risks and capture more market share.
The opportunity cost of not diversifying is the potential benefits of offering a wider range of products.
- A business is looking to make a choice between outsourcing a project, or keeping it in house.
Outsourcing can save on labour costs but may bring communication issues and quality control challenges.
The opportunity cost of outsourcing is the potential benefits of keeping the project in-house, including retaining control and developing expertise.
Factors to Consider when Calculating Opportunity Cost
When calculating the opportunity cost of a decision, there are several factors should be considered such as:
Timeframe
The timeframe refers to the length of time over which the potential costs and benefits of a decision will be realised.
When calculating opportunity cost, it is important to consider the time period, because the value of money changes over time.
For example, a decision that provides immediate benefits may not be the best decision in the long run.
Risk Tolerance
Risk tolerance refers to the amount of risk and uncertainty that an individual or organisation is willing to accept.
When calculating opportunity cost, it is important to consider the risk tolerance because some alternatives may have higher risks than others.
For example, a high risk investment may provide higher returns, but it also carries a higher risk of losing money.
Side Effects
Side effects are the consequences of a decision that are not reflected in the potential costs and benefits of the decision.
When calculating opportunity cost, it is important to consider other implications, because they can have a significant impact on the value of each alternative.
For example, a decision to invest in a factory may have positive economic benefits, but it may also have negative environmental effects that are not reflected in the potential costs and benefits of the decision.
Sunk Costs
Sunk costs are costs that have already been incurred and cannot be recovered, regardless of any future action or decision.
When calculating the opportunity cost, it is important to consider sunk costs because they are not relevant to the decision at hand.
For instance, if a business has invested $100,000 in a project that is no longer viable, the sunk cost should not be considered when evaluating alternative options.
Considerations when Calculating Opportunity Cost
When calculating opportunity cost, it is important to avoid common mistakes that can lead to poor outcomes such as:
Ignoring Implicit Costs
Implicit costs refer to the opportunity costs of using resources that have no monetary value.
For example, the time and effort spent on a particular activity may have an opportunity cost that is not reflected in the financial costs of the activity. Ignoring implicit costs can lead to an inaccurate evaluation of the true opportunity cost of a decision.
Failing to Consider All Options
When calculating opportunity cost, it is important to consider all possible options and their associated benefits and costs. Failing to consider all options can result in a limited view of the opportunity cost and lead to suboptimal decisions.
Not Considering the Time Value of Money
The time value of money refers to the fact that money available at present is worth more than the same amount of money in the future due to inflation and other factors.
Overlooking the time value of money can lead to an inaccurate evaluation of the opportunity cost of a decision, as future costs and benefits may be undervalued.
Confusing Opportunity Cost with Accounting Costs
Opportunity cost is the value of the next best alternative that is forgone when making a decision.
In contrast, accounting costs refer to the financial costs associated with a particular decision.
Confusing opportunity cost with accounting costs can lead to an inaccurate evaluation of the true opportunity cost of a decision.
Opportunity Cost Benefits
Helps in Making Informed Decisions
By considering the opportunity cost of a decision, more informed choices can be made that take into account the potential benefits and drawbacks of each option.
All of the costs and benefits of an activity are evaluated, not just the monetary ones. This can help to avoid making decisions that appear to be profitable in the short term, but are actually costly in the long term.
Encourages Efficiency
Opportunity cost encourages individuals and businesses to think about the most efficient use of their resources, as they must weigh the potential benefits of each choice against what they would be giving up by not choosing another option.
For example, if a company is deciding whether to invest in a new manufacturing facility or upgrade its existing one, the potential benefits and drawbacks of each option would be considered so that they can determine the opportunity cost of its decision.
I investing in a new production facility may provide the company with a larger space and higher production capacity, but it would also require significant investment, ongoing maintenance costs and potential delays in production.
On the other hand, upgrading the existing facility may be less expensive and less risky, but may also limit the company’s production capacity and ability to meet demand.
By considering the opportunity cost of each option, the company can make a more informed decision about the most efficient use of its resources, such as money, time, and employees.
Can Lead to Better Outcomes
By considering the opportunity cost of a decision, individuals and businesses may be able to identify new opportunities or ways to improve outcomes that they may not have considered otherwise.
For example, a small business owner might be deciding whether to expand their product line or invest in marketing. By evaluating the opportunity cost of each decision, the owner may determine that investing in marketing could potentially lead to increased sales and revenue, while expanding the product line may not generate the same level of return on investment. This new awareness may lead the owner to focus more on marketing efforts, resulting in increased customer sales and ultimately higher profits. Without considering the opportunity cost, the owner may have simply focused on product expansion and missed out on the potential benefits of investing in marketing.
Opportunity Cost Disadvantages
Can be Difficult to Measure
Opportunity cost is often difficult to measure, as it involves comparing the potential benefits and drawbacks of different options, which may not be easily measurable.
For example, if a business is considering expanding into a new market, they may see potential benefits such as increased revenue and market share, which may be measurable to some extent.
However, the potential drawbacks, such as increased competition and uncertain market conditions, may be more difficult to measure and may require a more qualitative analysis.
The opportunity cost of not entering the new market may also be difficult to quantify, as it may involve missed opportunities and lost potential profits that are not immediately evident.
May be Subjective
Opportunity cost can be subjective, as different individuals may place different values on different choices and opportunities, making it difficult to determine the “correct” opportunity cost of a decision.
For example, a company is considering two potential projects to invest in: Project A and Project B.
Project A is expected to generate a high return in the short term, while Project B is expected to generate a lower return in the short term, but has the potential to become more profitable in the long term.
The CEO of the company values long term growth and wants to invest in Project B, however, the CFO of the company values short term profits and disagrees with the decision.
The subjective nature of opportunity cost means that different individuals within the same company may have different opinions on which project would provide the greatest overall value.
Human Element of Decision Making
Opportunity cost assumes that people make logical and sensible decisions based on choosing the option with the highest expected return. However, in reality, this is not always true, and people often make decisions based on emotions or irrational thinking.
For example, a company has two options for investing their budget, either upgrading their existing equipment or launching a new marketing campaign.
The opportunity cost analysis shows that upgrading their equipment has a higher potential return on investment in the long run.
However, the marketing team convinces the company to launch the new campaign due to their emotional attachment to the project and the excitement it generates.
As a result, the company chooses the marketing campaign, despite the potential opportunity cost of not upgrading the equipment.
Can Lead to Analysis Paralysis
Overanalysing opportunity cost can lead to decision paralysis, where individuals and organisations become so focused on the potential benefits and drawbacks of each option that they fail to make a decision at all.
For example, if a business is trying to choose between two potential suppliers for a component used in their manufacturing process, they may spend so much time analysing the potential costs and benefits of each option, such as price, quality, reliability, and delivery time, that they become unable to make a decision and the project becomes delayed.