What Is An Opportunity Cost?

Every decision you make affects the trajectory of your life and business, so deciding between different paths is often incredibly overwhelming. You don't want to make the wrong decision and regret it later.

One way to make decision-making easier is to evaluate all of your options as objectively as possible. You must consider every available option, their costs and benefits, and weigh them against each other.

That's where opportunity cost comes into play. Once you understand opportunity cost, you'll be much more confident when making choices for your business.

Opportunity Cost 101

Financial decisions involve both direct and indirect costs that you must consider. Many people overlook opportunity costs when evaluating their options, leading to decisions that yield less than optimal results.

Don't overlook the importance of calculating opportunity cost in your business decision-making.

Definition

Opportunity cost is what you give up when pursuing one option instead of another. When you take any given opportunity, you can't take an alternative or enjoy its benefits. You're forgoing those benefits in favor of a different option.

The opportunity cost formula is:

Opportunity cost = Benefits from the next best alternative option - benefits from the chosen option

Note that it's often difficult to precisely calculate the benefits of an option you don't take. You can estimate how much you would have earned from that decision, but you won't know the actual performance beforehand. Use the potential benefit in your calculations.

Opportunity cost is one component of economic cost. The economic cost of a decision includes the actual accounting costs — the money that comes out of your pocket — as well as the cost of what you're giving up.

Using economic cost will give you a more holistic view of any given option's cost. You earn an economic profit when your revenue is higher than your combined explicit and opportunity costs.

How It Impacts Decision Making

Ideally, you should always choose the option that provides the largest benefits for the lowest possible costs. You can only do that if you know exactly what each path offers.

Sometimes, you have two paths that both provide cash flows. Is there really a wrong choice when they're both beneficial?

The concept of opportunity costs states that one option is better than the other because of the difference in the benefits they provide. An investment decision that earns you $1 million sounds great until you learn you could have used the same resources to earn $1.5 million with a different investment option. Then, it feels like you lost $500,000 instead of gaining $1 million. That's an example of opportunity cost.

Of course, you can only factor opportunity costs into your decision-making if you're aware of all of your options. Sitting down to calculate opportunity costs helps you brainstorm options and compare them as objectively as possible.

Its Importance In Economics

Opportunity cost in economics is a key concept. It helps you understand consumers' choices and how people allocate resources. Economics focuses on how people deal with scarcity, and evaluating opportunity costs is one way to manage those limited resources.

Role In Resource Allocation

Every government, business, and individual is working with limited resources. Selecting the right ways to allocate those resources is crucial to your success.

You want to allocate your resources in areas where they'll be the most productive. For example, it's better to invest your funds in new machinery that offers a 7% return than in a new plant that only provides a 3% return. Your resources serve you better when allocated to the machinery in this opportunity cost example.

If you allocate your resources to less productive areas, you will miss the opportunity to maximize their potential.

Remember that opportunity cost isn't static; it can shift over time. Increasing opportunity costs in one area should alert you that it's time to reconsider your resource allocation.  

Influence On Consumer Choices And Business Strategies

When you make decisions in your personal life as a consumer, you probably aren't sitting down to calculate opportunity cost figures. Even so, you likely consider in a general way what you're giving up and whether it's worth it whenever you make a choice.

However, consumer choices and business strategies alike are about keeping costs low and maximizing each decision's potential return. You can't do that unless you know all your options and their benefits.

Consider cost vs price. Every consumer and business purchase has a price tag attached to it — the actual money you pay. The cost of a decision is broader. It includes the literal price (if any) but also the lost benefits from options you did not choose.

How To Calculate It

Opportunity cost isn't a metric that will appear in your financial documents. If you want to know the opportunity costs associated with a decision, you'll need to calculate it yourself. Follow these steps.

Step 1: Identify Your Options

The first step in any opportunity cost calculator is to determine all of your options. If you're evaluating investment opportunities, for example, identify where you could invest your funds, including unconventional options.

If you overlook a viable option at this stage, you likely won't get an accurate assessment of your opportunity costs. List each option you come up with, even if some of them are not immediately appealing.

Make sure all of these options are mutually exclusive. If you can pursue some of these options while also selecting your top choice, they don't belong on the list.

Try asking business partners, friends, or family members to weigh in with any alternatives. Other people with unique perspectives can see the options you missed.

Step 2: Assess The Potential Returns Or Benefits Of Each Option

Next, you must quantify the returns or benefits of choosing each option. In many cases, it won't be immediately obvious how much a specific option will provide in benefits.

For example, if you're considering opening your own business as one option, you may not know exactly how much revenue your new business would generate. Use statistics from similar businesses in your area to estimate the benefits of this option.

Generally, it's easier to assess the returns on potential investment options. Look at the history of similar investments and their average returns to estimate what you would earn. For instance, the average stock market return was approximately 12% per year over the last decade.

Add the returns or benefits next to each option on your list so you can compare them.

Step 3: Determine The Next Best Alternative

Look over all the options you listed and their benefits. The choice with the highest potential returns or benefits is the "next-best alternative" to your chosen option.

If two options appear to provide equal benefits, choose one to act as the next-best alternative.

Step 4: Calculate The Benefits Of The Next Best Alternative

Once you determine the next best alternative, investigate its benefits. Spend some more time researching and estimating its value.

The more accurately you estimate the alternative's benefits, the more reliable your opportunity cost calculation will be.  

As you can see, opportunity cost is not an exact metric. The best way to use opportunity cost is to reference it alongside other intangible factors during your decision-making process. Don't fixate on the figures themselves.

Step 5: Identify The Opportunity Cost

Once you have all these numbers available, you can calculate the actual opportunity cost of each option.

Start with the benefits of the next-best alternative option. Subtract the value of your chosen option. The difference between these two numbers is your opportunity cost.

Hopefully, your chosen option provides greater benefits than the next-best alternative. If not, your calculated opportunity cost tells you how much you're missing out on by not taking that alternative path.

Example Calculations

Weighing the costs and benefits of each selection — including what you'd be giving up — is part of the standard decision-making process. Examining quantitative sample calculations of opportunity cost will help you understand this principle further.

Choosing A Career Path

Say you graduate from college and have the good fortune to receive two job offers. One job pays $40,000 annually and offers around $20,000 worth of yearly benefits. The other job pays $55,000 yearly without any benefits.

You're also considering entrepreneurship, which you estimate would earn you $45,000 in the first year and $80,000 in the second year. However, if you choose this path, you'll give up the chance to earn the salary from the two job offers.

Over two years, you would have earned $120,000 in value at the first job and $110,000 at the second job. $120,000 is larger, so the first job is the next best alternative.

Thus, the opportunity cost of deciding to be an entrepreneur in this situation is $120,000. Luckily, you expect to earn $125,000 in your first two years as an entrepreneur. The opportunity cost is lower than what you gain by making that decision.

Investing In Your Business

Calculating opportunity costs for business decisions is a similar process.

Let's say you're trying to decide whether to invest excess funds into the stock market or use that money to hire a new employee for your team. These two options are mutually exclusive — you can only choose one or the other.

The new employee would create value for your business, equating to a return on investment (ROI) of approximately 15% on their $100,000 salary each year. The same money invested in the stock market averages a yearly rate of return of around 10%.

If you choose to invest in the stock market, you'll earn $10,000, but you'll have an opportunity cost of $15,000. The explicit costs are the same, but the implicit costs show that hiring a new employee is smarter.

Its Role In Personal Finance

Most people intuitively understand opportunity cost, at least in an abstract sense. You know, for example, that if you choose the chicken dinner at a wedding, you won't get to eat the vegetarian meal.

Still, you can improve your personal finance decision-making by actually calculating your opportunity cost, at least for major choices.

For example, when you're thinking about moving, evaluate your options through the lens of opportunity cost. If you purchase a house, you'll have to tie up a large chunk of money in the down payment and closing costs, but you'll have an asset that starts to grow in value for you (hopefully).

If you rent an apartment instead, you won't need such a large initial outlay of cash. However, your rent is an ongoing expense, and you won't gain an asset. Compare each option's actual and opportunity costs to determine which is the better choice.

Using opportunity cost in your personal finance decisions will give you a deeper understanding of your options. You will probably realize some options you weren't seriously considering are better for your finances than you thought.

Start Leveraging It For Your Business

Every decision you make for your business involves a trade-off. If you choose to invest in the stock market, you can't use those funds to hire new employees. If you open a new production plant, you can't use that money to invest in development.

You're always giving something up in favor of something else. The key to growing your business and being as successful as possible is making sure the option you're giving up is less valuable than the one you're choosing.

Calculate opportunity cost before a major business decision. Leverage this information to make better choices about where to allocate your resources. If you calculate opportunity cost and see that another option seemingly provides greater benefits, strongly consider pursuing that option instead. That way, you'll get as much out of your investments and other decisions as possible.

Consider asking an expert when you're facing a big business decision.