What is opportunity cost?

Opportunity cost can be understood as the “positive that could have happened if the other option had been chosen over the choice we made.” It helps to make informed decisions by considering the potential benefits of alternative choices.

Tangible costs vs. intangible costs

Tangible and intangible costs are two important business expense categories. While tangible costs provide a clear and quantifiable basis for financial decisions, intangible costs offer insights into less obvious but potentially significant impacts on a business. 

Tangible costs can be easily measured and quantified in monetary terms (e.g., physical assets, such as equipment, materials, and labor). 

Intangible costs, on the other hand, are more difficult to measure and quantify because they are often associated with non-physical assets (e.g., reputation, customer satisfaction, and employee morale). 

Overlooking intangible costs can lead to unexpected negative consequences in the long run. If a company dismisses gaining a negative customer service reputation because it’s an intangible cost, for instance, the result can lead to plummeting sales.

While tangible costs are crucial for financial planning and budgeting, intangible costs are just as important because they can impact a company in big ways, including its future success and competitiveness. 

Explicit vs. implicit costs

Explicit costs can be measured in monetary terms. 

They are direct, out-of-pocket payments for resources or services that a business needs to operate. These costs are easily identifiable and recorded in the company's financial statements. For example, explicit costs include wages, rent, and the cost of raw materials. 

Implicit costs, on the other hand, represent the opportunity cost of using resources that are owned by the business. They are difficult to measure precisely in monetary terms. An example of an implicit cost is the foregone salary of an entrepreneur who is now working in their own business and no longer receives a salary for their job as an employee.

Understanding both explicit and implicit costs is crucial for business owners because it can help them decide where to allocate resources. While explicit costs are more straightforward to track and manage, recording implicit costs may provide a more comprehensive view of a company's economic performance and help to inform strategic decisions.

Opportunity cost vs. risk

Opportunity cost is the value of the next best alternative that must be given up to pursue a certain action. What are the benefits of the alternative course of action? That’s the opportunity cost.

Risk, on the other hand, focuses on the potential negative outcomes of a chosen option. It involves uncertainty about future events and their consequences.

Opportunity cost and risk are related concepts, as both involve making decisions under conditions of uncertainty. 

When evaluating the opportunity cost of a decision, it’s also important to factor in the risks associated with that decision. For instance, a decision with a high opportunity cost could also carry a high level of risk.

Opportunity cost vs. sunk cost

Opportunity cost is the value of the next best alternative that must be sacrificed to pursue a certain action. 

Sunk cost, on the other hand, refers to costs that have already been incurred and cannot be recovered. These costs are not affected by future decisions and should not be considered when making decisions about future actions.

When comparing the two, opportunity cost represents the potential benefits of choosing a different course of action, while sunk cost represents costs that have already been incurred and cannot be changed. 

How to calculate opportunity cost

Opportunity cost depends on the decision maker's specific situation and preferences. Therefore, to calculate opportunity cost, you will identify the two mutually exclusive alternatives and then compare the benefits and costs of each option. 

Opportunity cost formula

Opportunity Cost = Return on Best Foregone Alternative - Return on Chosen Option

This formula is often used to compare options and optimize resource allocation. 

The return on the best-foregone alternative is the return on the option that you did not take. 

The return on the chosen option is the alternative that you did pursue.

Opportunity cost formula per unit

Per Unit Opportunity Cost = Total Opportunity Cost / Number of Units

To calculate opportunity cost per unit, follow these steps:

1. Identify the total opportunity cost for the entire production or decision.
2. Determine the total number of units produced or involved in the decision.
3. Divide the total opportunity cost by the number of units.

Techniques for assessing the potential return on options

Return on options refers to the profit or loss an investor makes from trading options. 

When assessing the potential return on options, investors can use several techniques to evaluate risk and potential rewards. In addition to the opportunity cost calculation, here are some key methods:

1. Risk-Return Tradeoff Analysis: This fundamental principle suggests that higher risks are typically associated with higher potential returns. For options, this means considering the balance between the potential profit and the risk of losing the premium paid.
2. Sharpe Ratio: This metric helps assess whether the potential return justifies the risk undertaken. It compares adjusted returns to risk levels, providing insight into the risk-adjusted return of the option investment.
3. Alpha Ratio: This measures the excess returns generated by an option compared to a benchmark return. It can help evaluate the option's performance relative to the underlying asset or a market index.
4. Beta Analysis: While more commonly used for stocks, beta can be applied to options to understand how the option's price might move in relation to the underlying asset or stock market.
5. Time Value Analysis: Since options have expiration dates, assessing the time value and how it decays is crucial for understanding potential returns.
6. Volatility Assessment: Analyzing both historical and implied volatility can help estimate potential price movements and returns.
7. Scenario Analysis: Creating multiple scenarios (best-case, worst-case, and most likely) can provide a range of potential returns.
8. Options Pricing Models: Using models like Black-Scholes can help theoretically evaluate options and assess potential returns.
9. Risk Measurement Metrics: Metrics such as standard deviation, Value at Risk (VaR), or options Greeks (delta, gamma, theta, vega) can provide insights into options' risk and potential return characteristics.

Opportunity cost is forward-looking

Opportunity cost can be used to calculate past business decisions to analyze past performance and identify missed opportunities. However, it is mostly a forward-looking metric to estimate potential opportunity costs.

Limitations of opportunity cost analysis

Running an opportunity cost analysis is a useful method to make decisions, but it has limitations. Some of the limitations of opportunity cost analysis include:

• Difficulty in accurately estimating future costs and benefits: Opportunity cost analysis requires making assumptions about future costs and benefits, which can be difficult to estimate accurately.
• Subjectivity in assigning value: The value assigned to different alternatives can be subjective and may vary depending on the individual or organization making the decision.
• Ignores externalities: Opportunity cost analysis may not consider externalities or the costs and benefits that affect parties other than the decision-maker.
• Limited by available information: The accuracy of opportunity cost analysis is limited by the information available to the decision-maker. If relevant information is unavailable or not considered, the analysis may be flawed.

Accounting profit vs. economic profit

Accounting profit is the company's total revenue minus its explicit costs. Note that explicit costs are the actual monetary, out-of-pocket expenses. The accounting profit is reported on a company's financial statements and is used to calculate its taxable income.

Economic profit, on the other hand, is the difference between a company's total revenue and the sum of its explicit and implicit costs. Implicit costs are the opportunity costs of the resources used by the company, such as the owner's time and capital. 

Economic profit takes into account not only the actual monetary expenses of the company, but also the value of the opportunities the company has given up to pursue its current course of action.

To sum it up, accounting profit considers only explicit costs, while economic profit counts both explicit and implicit costs, giving a more holistic view.

Opportunity cost formula examples

Burnt, a company in the restaurant industry

burnt, a startup in the restaurant industry that reimagines how chefs and suppliers work together, provides back-of-house automation for restaurants, including recipe management, inventory forecasting, automated procurement, and much more.

So, let’s assume that burnt has $40,000 in available funds. In this scenario, the CEO, CFO, and finance team must choose between investing in securities, which they expect to return 20% a year, and using the funds to purchase new hardware and software. The opportunity cost is the foregone cost of what was not chosen, regardless of the option selected.

If the leadership team at burnt decided to invest in securities, the investment would theoretically gain $4,000 in the first year, $4,400 in the second, and $4,830 in the third.

The other option is investing in new hardware and software. 

Getting the team up and running with the new equipment would include employee training and management. Let’s assume the team will not be completely set up with the equipment for several years due to staff onboarding and training. Knowing that, the company could estimate that it would net an additional $1,000 in profit in the first year by using the updated equipment, then $4,000 in year two, and $10,000 in all future years.

From these calculations, choosing the securities makes a bigger profit in the first and second years. However, by the third year, the new software and hardware is the better option.

Opportunity Cost = Return on Best Foregone Alternative - Return on Chosen Option

Securities profit by year: 4,000 + $4,400 + $4,830 = $13,230

New software and hardware profit by year: $1,000 + $4,000 + $10,000 = $15,000

= $13,230 - $15,000

= $1,770

When allocating extra funds, it’s important to consider the opportunity cost of each possible use of funds. This means reviewing each option and its potential and subsequently choosing the one that provides the most significant net benefit. 

Increase headcount vs. acquire software

Several factors, including cost, efficiency, scalability, and expertise, should be considered when deciding whether to increase headcount or acquire software. 

• Cost: Compare the cost of hiring new employees, including salary, benefits, and training, to the cost of acquiring and implementing new software.
• Efficiency: Consider whether the new software can automate tasks and increase efficiency, or if additional employees are needed to handle the workload.
• Scalability: Think about the long-term growth of the company and whether increasing headcount or acquiring software is more scalable and sustainable.
• Expertise: Determine if the tasks require specialized skills and knowledge that only new employees can perform, or if the software can provide the necessary expertise.

Ultimately, base your decision on carefully analyzing the company's needs, goals, and resources.

Invest contribution margin externally vs. internally

Investing contribution margin internally means reinvesting profits back into the company. Investing contribution margin externally means distributing profits outside the company.

Here are some factors to consider for investment options:

• Growth opportunities: If there are attractive growth opportunities within the company, it may make sense to invest the contribution margin internally to expand operations, develop new products, or enter new markets. 
• Risk: Investing internally may carry less risk than investing externally, as the company has more control over its own operations. However, diversifying investments externally can also help to mitigate risk.
• Return on investment: Compare the potential expected return on investment for internal and external investment opportunities to determine which option is likely to provide the greatest benefit.

Ultimately, investment decisions should be based on a careful analysis of the company's needs, goals, and resources.

FAQs about opportunity cost

Is there a formula for opportunity cost?

Yes, the following formula for opportunity cost is often used to compare options and optimize resource allocation.

Opportunity Cost = Return on Best Foregone Alternative - Return on Chosen Option

Is opportunity cost included in cash flow?

No, opportunity cost is not included in cash flow. Cash flow refers to how much money flows in and out of the business, while opportunity cost represents the potential benefits that are foregone as a result of choosing one option over another. 

Opportunity cost is an economic concept that is used to evaluate the trade-offs between different options. It is not a cash flow item and is not included in cash flow statements.

Is opportunity cost included in IRR?

No, opportunity cost is not included in the calculation of the Internal Rate of Return (IRR). IRR measures how profitable an investment or project is. Opportunity cost, on the other hand, represents the potential benefits that are lost because one option, for instance, an investment, was chosen over another. 

What is constant opportunity cost?

Constant opportunity cost is an economic concept where the opportunity cost of producing a good remains constant as the production of the good increases. This means that the cost of giving up one unit of a good to produce another unit of a different good remains the same, regardless of how much of each good is being produced. 

Conclusion: Make better financial decisions with Rho 

Opportunity cost is the value of the next best alternative option that must be given up when making a choice. In other words, opportunity cost measures the potential benefits that were not received or gained because another option was selected. It helps startups evaluate trade-offs and make more informed decisions.

As a high-growth, ambitious startup, you may want to reduce redundancies and add value to your operations. 

With Rho’s business banking platform, you can get up and running with an all-in-one solution. It includes accounting integrations and, ultimately, saves finance teams time and money. 

Book a demo today!

Rho is a fintech company, not a bank. Checking and card services provided by Webster Bank, N.A., member FDIC; savings account services provided by American Deposit Management Co. and its partner banks.

Note: This content is for informational purposes only. It doesn't necessarily reflect the views of Rho and should not be construed as legal, tax, benefits, financial, accounting, or other advice. If you need specific advice for your business, please consult with an expert, as rules and regulations change regularly.

‍

‍

‍