Owning a business is about making choices: where to set up shop, what to sell, and whom to sell to. Every business decision you make has trade-offs. Often, making one choice for your business will make the next best alternative impossible. To determine the best course of action, you’ll need to determine the relative benefits of each alternative. This is where opportunity cost comes in.
What is opportunity cost?
In economics, opportunity cost represents the potential gain that is lost when choosing one investment choice over another. In short, it’s a value of the road not taken.
Unlike the explicit costs that are recorded in your accounting ledger, opportunity costs are implicit costs that arise when you allocate existing resources toward one business goal, thereby foregoing the ability to allocate them toward another one.
Opportunity costs are easy to overlook, but understanding missed opportunities is crucial to better decision-making in business.
How opportunity cost works
For a simple example, let’s say you opt to rent retail space in midtown Manhattan at the bargain price of $10,000 per month. By signing that lease, you are eliminating the opportunity to rent in SoHo, or the Upper East Side, or even 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, opportunity cost is positive, such as if you gave up the chance to locate in a terrific corner store that was renting for just $2,000 per month. Sometimes opportunity cost is negative, such as if your next-best option was retail space a block over that was renting for $15,000 per month.
Calculating opportunity cost
Opportunity cost can be reduced to a simple formula:
Opportunity cost = FO - CO
FO and CO are the expected returns of your foregone option (i.e., the one not chosen) and your chosen option, respectively.
Let’s look at some examples of opportunity cost in action. Imagine you have a company faced with two mutually exclusive options:
- Invest excess capital in developing a new product line
- Invest excess capital in marketing your existing product
Let’s assume the expected return on investment (ROI) of developing a new product is 10% over the next year and you expect increased marketing spend to generate a 15% return over the same interval. The opportunity cost of prioritizing the new product over your existing product is 5%. In other words, by creating a new product, you’ll be forgoing the opportunity to earn 5% more over the next year.
Of course, opportunity cost analysis can change depending on your time frame or perspective. For instance, in the above example, imagine that spending money to create that new product would generate a 50% ROI over five years, while marketing ROI would top out at 25%. Now, your opportunity cost is -25%, which means you’ll be foregoing the “opportunity” to earn 25% less over time.
Marginal opportunity cost
Marginal opportunity cost combines marginal costs and opportunity costs to determine the effects of producing each additional unit of a product on the overall costs of running your business.
For instance, in the above example, let’s say that the marginal cost to produce one unit of your new product is $2. Because money spent to manufacture that unit is money you can’t spend on a digital advertisement, you could say that the marginal opportunity cost is actually $2 plus one advertisement.
Opportunity cost vs. sunk cost
Opportunity costs are forward looking, with the goal of understanding what future value you may miss out on by making a financial decision for your business. By contrast, sunk cost refers to the resources you have “sunk” into a particular project or goal in the past.
Sunk costs are relevant to opportunity costs because they can lead you astray via the “sunk cost fallacy.” This logical trap says that because you have spent a certain amount of resources on a project, you should continue to pursue it instead of choosing an alternative. When considering opportunity cost, be sure to ignore sunk costs previously incurred and focus on the potential benefits of one alternative over another.
Opportunity cost factors to consider
As another example, imagine you’re deciding whether to partner with Amazon to sell your new product. Here, your opportunity cost is the potential to partner with other retailers in the future. 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 for decision makers evaluating several alternatives, ensuring that your best course of action has the lowest downside.
Using opportunity cost 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.
Ultimately, 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.