Opportunity cost: formula, calculations, considerations, and examples
Maximize your business decisions by understanding what you give up.
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1 minute
October 4, 2024
Isabel Peña Alfaro is a guest contributor. The views expressed are theirs and do not necessarily reflect the views of Rho.
Did you ever read a Choose Your Own Adventure book as a kid? These are books in which you, as the reader, get the chance to choose the next steps of the protagonist, leading you to a final result amongst many endings. The reader usually wonders, what if I had chosen another option? What did I miss by choosing this option?
Well, opportunity cost is a grown-up, real-life version of Choose Your Own Adventure.
Essentially, the concept of opportunity cost is that you’re tracking the potential benefits that you may miss out on when choosing one adventure, or business alternative, over another.
In this article, we’ll dive into how to calculate opportunity cost, accounting versus economic profit and important considerations for startups. We’ll also go over opportunity cost examples.
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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 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 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 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 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.
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 = 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.
Per Unit Opportunity Cost = Total Opportunity Cost / Number of Units
To calculate opportunity cost per unit, follow these steps:
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:
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.
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:
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.
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.
Several factors, including cost, efficiency, scalability, and expertise, should be considered when deciding whether to increase headcount or acquire software.
Ultimately, base your decision on carefully analyzing the company's needs, goals, and resources.
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:
Ultimately, investment decisions should be based on a careful analysis of the company's needs, goals, and resources.
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
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.
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.
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.
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.
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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.