As a business owner, you make decisions based on limited resources. When you choose one option, however, you may have to give up something else: that tempting other option. You’re essentially deciding that the value of option A will exceed the value of option B.
Learning about what’s involved in these trade-offs can help you make more informed decisions for your business. That’s the opportunity cost you’re evaluating. Here’s more about it and a few opportunity cost examples.
What is opportunity cost?
Opportunity cost is the value of what you sacrifice to pursue one option over another. You encounter opportunity costs in everyday life, including in business. When you decide to spend some of your company’s profits upgrading your office equipment, for example, you give up any potential gains from other actions, such as hiring new employees.
Calculating the opportunity cost of a choice can guide your decision-making process because it gives you a rationale to pick what you hope is the best option. To calculate opportunity cost, at a basic level, subtract the value of what you choose from the value of what you forgo.
Explicit vs. implicit costs
Opportunity costs come in the form of explicit and implicit costs.
- Explicit costs. These are out-of-pocket expenses your business incurs when producing goods or services, such as wages you pay employees and rent payments for your office space.
- Implicit costs. These arise from resources you already own that could have been put to use in some other way. The most important implicit cost is time—any time you spend doing one thing is time you can’t spend doing something else.
Opportunity cost differs from sunk costs, which is money and time you already spent on something, like developing a new product, that you can never get back. Since you can never get them back, sunk costs should not be factored into your decision-making about choosing one option over another.
4 examples of opportunity cost
- Renting a manufacturing plant
- Choosing whether or not to introduce a product line
- Picking a shipping option
- Deciding whether or not to offer discounts
Here are four opportunity cost examples to help you understand how the concept works.
1. Renting a manufacturing plant
A growing ecommerce business has decided to rent a manufacturing plant to house its products and is choosing between two options. Plant A rents for $10,000 per month. Plant B is the same size and rents for $6,000 per month but is located 20 miles away. The business could save money by going with Plant B. The explicit opportunity cost of choosing Plant A would be $4,000 per month.
But the implicit opportunity cost includes commuting time. The total opportunity cost includes both the dollar amount and the time spent commuting to the plant. The business owner must ask themselves if the time spent commuting to the less-expensive plant is worth $4,000 or more per month. That way, they can decide if Plant B is “worth it” and is less expensive considering all the costs.
2. Choosing whether or not to introduce a product line
A company is considering whether to spend $150,000 to introduce a new product, though it’s not sure it will sell. The company already spent $10,000 on developing the new product—this is a sunk cost, or money the business spent on something that it can’t recoup. It shouldn’t be included in the calculation of whether to introduce the product.
The opportunity cost of deciding to debut this product is $150,000, which can’t be spent elsewhere, such as developing a different product line, hiring more employees, or earning money from the stock market. Introducing this product forgoes the future earnings from putting that money in those other places—though it would be the better choice if those alternatives didn’t bring in as much revenue as the new product will.
3. Picking a shipping option
An ecommerce business is deciding whether to ship its products directly to customers or to hire a third-party logistics provider. It estimates it will cost $50,000 per year to outsource the shipping duties. This amount is the explicit cost, but the business owner will also save a lot of time and energy (implicit costs) because they won’t have to focus on shipping logistics. They could then spend their time on activities such as developing new products, which may lead to new revenue streams over time.
4. Deciding whether or not to offer discounts
A business notices a slowdown in sales of an important product. There’s $20,000 of it left in inventory, and the company could offer a 15% discount to get rid of the remaining supply. Doing so means the business would no longer be spending money on carrying costs, which include interest on financing, warehouse rent payments, and insurance for that supply. The annual carrying cost for holding the inventory is $5,000 while discounting the product would mean losing out on $3,000 of revenue. The opportunity cost of discounting the product is the difference between the carrying costs and the lost revenue, or $2,000.
Opportunity cost example FAQ
Can opportunity cost impact pricing decisions in ecommerce?
Yes, opportunity cost can apply to ecommerce pricing decisions. If you offer a discount on a product, for example, you might gain more customer loyalty or clear space for new inventory. But it means you would lose something in the process—namely the potential revenue if that product had been sold at the original price.
Is opportunity cost relevant to both small and large ecommerce businesses?
Yes, opportunity cost is relevant to businesses of all sizes. Small businesses in particular usually have less capital and more limited resources, so calculating opportunity cost is especially important for making informed decisions.
Can opportunity cost be avoided in decision-making?
Businesses don’t have to calculate the opportunity cost for every decision. However, because you’ll always forgo an option when pursuing another, it’s wise to consider the value of what you’re giving up.
How do you calculate opportunity cost?
At a basic level, calculating opportunity cost is a matter of finding the cost of each choice and then subtracting the cost of the chosen outcome from the cost of the alternative:
Opportunity cost = cost of alternative outcome - cost of chosen outcome
Businesses will sometimes use more complicated financial modeling to figure out the opportunity cost of different financial decisions.