Calculating Opportunity Cost: What Would You Give Up?

Real Money Talk

What was the last decision you made? Opportunity cost is what you sacrificed by picking the option you did. We sometimes look back on our choices and wonder “what would have happened if we had chosen option B?” Believe it or not, even doing nothing has an opportunity cost, so it’s important to consider when contemplating a decision.

What Is Opportunity Cost?

unbalanced-scale-illustration

Opportunity cost is what you sacrifice by choosing one alternative over another. Understanding opportunity cost is helpful for strategic decision making and long-term planning. It reminds us to take a close look at all options to ensure you’re making the right choice.

In business, opportunity cost can be thought of as economic cost. Businesses have limited resources and money, so they look at opportunity cost to figure out where they’ll receive the greatest or safest return. It’s also a way to weigh potential risks and results before they happen.

Opportunity cost can be broken down in two ways:

Explicit Opportunity Cost

Explicit costs are expenses that can easily be accounted for. If a start-up allocates $1,500 towards standing desks for their employees, the explicit opportunity cost is what they could have done with the $1,500 elsewhere, such as put it towards researching a new project.

Implicit Opportunity Cost

Implicit costs are intangible costs that are not easy accounted for. Essentially, it refers to the loss of potential funds, not the actual funds. If a company invests time and employee resources in volunteering for a non-profit, the implicit opportunity cost is the money they are earning by not having employees at work.

Sunk Costs

Sometimes confused with opportunity cost is sunk cost, but the concept is very different. Sunk costs are costs that have already been incurred and cannot be recovered. If a company invests in a project that goes south, they may continue to invest in it, so they don’t lose out on their investment entirely. It’s when you’re so far into a decision that it seems too expensive to undo.  

How to Calculate Opportunity Cost

how-to-calculate-opportunity-cost-illustration

Just as there’s no way to predict exactly what will happen as a result of your decisions, there isn’t a specific formula to calculate opportunity cost. However, you can think about it as a ratio between two choices. Opportunity cost is the ratio of what you sacrifice to what you gain.

Examples of Opportunity Cost

crossing-roads

Opportunity cost may seem simple, but it can have a powerful outcome. It isn’t measured solely in monetary returns, either.

Sarah is overdue to visit her family in San Diego, but gets an opportunity to book a $600 round trip flight to Asia with her friends. If she decides to book the flight, she can’t then spend that time or money on anything else. If the next best alternative to traveling to Asia is visiting her family in San Diego, then the opportunity cost is the $600 plus the quality time she would have spent with her family.

Businesses have limited time, money, and resources, so opportunity cost is commonly referred to in business decision making. If a tech company invested $100K in a new product line and generates a 4% return, but later finds they could have generated 7% on a different investment, that 3% is the opportunity cost of their decision.

What to Consider with Opportunity Cost

woman-at-computer-making-decision

There’s an opportunity cost in every decision we make, from weekend plans to business investments. Consider these three factors when making a decision, so you can pursue the right choice and minimize opportunity cost:

  • Funds: Where else would you spend your money?
  • Time: How would you spend your time elsewhere?  
  • Energy: Is it worth the effort?

How you make a decision or pursue an opportunity will vary based on your experience, finances, age, and personal situation. Always evaluate each alternative to make as informed of a decision as you can. Maximize your long-term goals and decide if your funds, time, and energy could be better spent somewhere else.

Decisions affect not just our finances, but other critical aspects like relationships, productivity, and lifestyle. Calculate opportunity cost to yield the best outcome, to the best of your ability.

Sources: Investopedia | Inc

Leave a Reply