Opportunity cost is a term in economics used to describe benefits that are lost when choosing one option over another. In short, it’s a value of the road not taken. Opportunity costs are easy to overlook, but understanding missed opportunities is crucial to better decision making in business.
Weigh all your options
For example, by opting to rent retail space in midtown Manhattan at the bargain price of $10,000/month, you are eliminating the opportunity to rent in SOHO, or the Upper East Side, or even Jersey City, New Jersey. Assuming your other options were less expensive, the value of what it would have cost to rent elsewhere is your opportunity cost.
Sometimes the opportunity cost is high, such as if you gave up the chance to locate in a terrific corner store that was renting for just $2,000/month. And sometimes it is low, or negative relative to what you will now spend, such as if your next-best option was retail space on the next block that was renting for $15,000/month.
Choosing how to invest your resources
The concept behind opportunity cost is that, as a business owner, your resources are always limited. That is, you have a finite amount of time, money, and expertise, so you can’t take advantage of every opportunity that comes along. If you choose one, you necessarily have to give up on others. They are mutually exclusive. The value of those others is your opportunity cost.
Big picture, opportunity cost is more about the choices you make than about money or resources. It’s about keeping in mind that one action or choice can preclude you from taking advantage of other options.
Factors to consider
So, as another example, the opportunity cost of deciding to partner with Amazon to sell your new product is the potential to partner with other retailers. You have to decide if, given your other alternatives, the opportunity cost is worth it.
In this case, you might weigh:
- The amount of traffic Amazon gets daily
- The average value of a sale
- The retail price of your product on Amazon
- Your profit margin
- Anticipated sales levels
- Length of exclusive partnership
- Conditions under which you can exit the partnership
Opportunity cost can be useful in evaluating several alternatives, to ensure that your best course of action has the lowest downside.