Table of Contents
- What is Opportunity Cost?
- Examples of Opportunity Cost (How It Works)
- Opportunity Cost Formula
- How To Calculate Opportunity Cost
- Frequently Asked Questions: Opportunity Cost
In the world of business, the specifics of opportunity cost and how to calculate opportunity cost are sometimes misunderstood. This page will tell you everything you need to know about opportunity cost and answer the following key questions:
- What is opportunity cost?
- What are some real-life examples of opportunity cost (personal and business)?
- How do I calculate opportunity cost?
- How can I use opportunity cost to make better business decisions?
What is Opportunity Cost?
Opportunity cost refers to what you miss out on when you choose one option over another.
Ordinary costs are simple and straightforward. You see that a supplier charges $10 for a certain part—and that’s your cost.
Opportunity cost is different because it’s not always completely obvious. You need to calculate opportunity cost in both the short- and long-term to fully understand what you are missing out on by choosing one option over another. Without this type of calculation, you may make a decision that appears to be the best choice on the surface—but actually isn’t efficient in the long run.
The following examples will help you to further understand what opportunity cost is. Once we understand the basics, we can move onto applying the concept to make better business decisions.
Examples of Opportunity Cost (How It Works)
Imagine you walk by a food truck that sells tacos. Your stomach growls and you decide to purchase a premium taco for $5.
In this example, your obvious cost was $5. But what did you sacrifice in the form of opportunity cost to be able to afford the taco?
You continue on your way and you see a smoothie stand. You’re thirsty so you order a smoothie, the cashier tells you that the smoothie is $5. You open up your wallet and realise you spent your last $5 at the taco truck. You awkwardly inform the cashier that you can’t pay for your smoothie and walk away sheepishly.
In this example, by purchasing the taco, your opportunity cost was not being able to purchase the smoothie later on. Specifically, this was the short-term opportunity cost of purchasing the taco.
Imagine you enjoyed the taco tremendously—and you make a habit of purchasing the same taco every single day. At the end of the month, your friend invites you to go out for drinks—but you can’t afford to go out because you have continuously spent money on tacos throughout the month. Not being able to purchase a smoothie was your short-term opportunity cost. Now, not being able to go out for drinks is your long-term opportunity cost.
In life and in business, everything is a tradeoff. Purchasing the taco on day one and throughout the rest of the month may have been the absolute best decision you could make. Maybe the smoothie wasn’t that good, and maybe you wouldn’t have had a good time if you had gone out for drinks with your friend.
But without understanding opportunity cost, you would have no way of knowing that the taco purchases were, in fact, the best decision you could make. For this reason, opportunity cost is very important when it comes to business decisions. If you don’t calculate opportunity cost, you potentially miss out on all sorts of opportunities that could have led to greater business success.
Here’s an example that’s more specific to business. Imagine you run a marketing agency and you have a team of five full-time employees. A client approaches you and offers to pay you a $50,000 monthly fee to handle all of their marketing needs. You accept the offer, sign the contract, and send the first invoice without calculating opportunity cost. Now you’re locked in. Two days later, two separate clients approach you and each offers you a $30,000 monthly fee to handle their respective marketing needs. You can carry out the marketing campaigns for the two smaller clients with your same team of five. In this example, you have sacrificed $10,000 each month because you did not calculate the opportunity cost of taking on the single client for the $50,000 monthly fee.
Opportunity Cost Formula
The basic formula to calculate opportunity cost is simple:
Opportunity cost = The return of the option not chosen – The return of the option chosen
In the business example given above, your opportunity cost was $10,000 because the formula was:
Opportunity cost = ($30,000 X 2) – $50,000
How To Calculate Opportunity Cost
Calculating opportunity cost can be difficult because not all future variables can be known in the present moment. In the business example above, there’s no way that you could have known that two clients would have approached you a mere two days later and offered you a better deal on the work your team could accomplish.
That being said, the consideration of opportunity cost is always possible. For example, when accepting the $50,000 monthly contract, you must keep in mind that accepting such a contract will completely remove your ability to take on new clients, at least in the short-term while you maintain your team of five.
Calculating opportunity cost becomes more difficult as business decisions become broader in scope, especially when complex financial variables, such as debt, interest and net working capital start getting involved.
Overall, opportunity cost is simple to understand—but hard to master. Many leading businesses have gotten to the top by making intelligent business decisions based on opportunity cost while their competitors did not.
Keep opportunity cost in mind every time you make a business decision—even a seemingly simple one—and you will give yourself the best chances of succeeding in both the short- and long-term.
Frequently Asked Questions: Opportunity Cost
How do you calculate opportunity cost on a PPC (Production Possibilities Curve)?
A PPC can be used to show the differences in opportunity cost between two products that you can build or manufacture.
For example, if a jeweler is deciding whether to make necklaces or bracelets, the formula would be:
Opportunity cost = Total potential revenue or profit from making only necklaces – Total potential revenue or profit from making only bracelets
By using a PPC, business owners can intelligently plan their business models around products that will result in the highest amount of revenue or profit.
Which business decisions are most susceptible to negative outcomes because of opportunity cost?
In general, the larger the decision, the more potential fallout there is via opportunity cost. In the PPC example above, focusing on necklaces when bracelets would actually result in more revenue/profit would be a potentially fatal business error right out of the gate. Similarly, when large sums of money are involved, the potential for negative outcomes due to opportunity cost is increased.