Opportunity Cost
What is opportunity cost?
Opportunity cost is the potential value lost by not pursuing a particular course of action. It’s the “what could have been” scenario, usually measured in terms of financial benefit. Many businesses, investors and individuals use this metric to choose the most profitable alternative over another. Analyzing the potential missed opportunities allows for more cost-effective decision-making.
While the term originates from economics, opportunity cost has expanded to many diverse business contexts. The “cost” can be defined in terms of money, time, output, or any other finite resource.
When it comes to starting a business, one has to learn how to navigate a complex ecosystem of multi-layered tasks with many important financial decisions. From developing a low-risk business idea to creating a website and expanding a company intelligently, there are numerous opportunity costs to consider when launching a new venture.
Opportunity cost examples
Business: Opportunity cost plays a significant role in most business decisions. Companies or investors want to know the cost of the forgone benefit that would have occurred from an option not chosen. For instance, if a company wants to expand into a new market like Asia, Europe, or South America—the CEO will probably ask to review the estimated cost of each possible venture—as well as the potential revenue each new region could bring. Business analysts predict the company could generate $15 million in Asia, $10 million in Europe, and $18 million in South America. These predictions show there are much greater benefits derived from the South American market. Therefore, it holds the highest opportunity cost of neglecting that region.
Time: Calculating opportunity cost in terms of time can often be more abstract. For example, the decision to spend time meeting an old client for lunch instead of making 20 phone calls to new prospective clients during that time has an opportunity cost associated with it. The opportunity cost of those lunch hours becomes all that one could not do otherwise. While there’s no official price tag associated with each of these activities, one might decide what they “miss out on” by not calling 20 new clients is less critical than what they would give up by not meeting that individual client who could do more business with them.
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Opportunity cost formula
To calculate opportunity cost, follow the formula below:
Opportunity Cost = FO – CO
FO = Return on best forgone option
CO = Return on chosen option
The difference between the expected returns of each option will lead to the opportunity cost number. As a result of this opportunity cost formula, one can better understand the profit margin and see the more strategic choice. This formula can lead to a monetary value that business owners try to estimate to the best of their ability when making financial decisions.
For fields outside of business, opportunity cost is more about the choices one makes than it is about calculating exact costs with a calculator. The key principle behind opportunity cost is remembering that taking action or making a decision implies that some finite resource is forgone.
Opportunity Cost vs. Sunk Cost
Sunk cost is the lost funds that have already been spent, whereas opportunity cost is money or time one has not yet spent but would miss out on if not pursuing that option. The term sunk cost suggests the individual or business won’t be getting that investment back, whereas opportunity costs suggest one can earn that same money—if not more—when invested differently.
For example, if a business spends $10,000 on an advertising campaign that failed to meet KPIs and did not yield a positive ROI, this investment was a sunk cost. In contrast, choosing between funding an influencer marketing campaign vs. a referral program in the future has an opportunity cost associated with the option not selected to implement into a business plan.