Opportunity costs are the gains lost by selecting one choice over another. Though intangible and impossible to assess, they may strongly influence decision-making. This article will define opportunity costs, quantify them, and explain how they affect business choices. I will also give a business case where opportunity costs matter.
What are opportunity costs?
Opportunity cost is “the potential benefits that a business, an investor, or an individual consumer misses out on when choosing one alternative over another.” Forward-looking, it compares and balances option returns. If a person has $1000 and may put it in a stock with a 10% or a 5% expected return, the bond’s opportunity cost is 5% (10% – 5%), the forgone benefit of investing in the stock. (Khan Academy, 2019) Opportunity costs might be explicit or implicit. It costs money to buy a product or hire a person. Unused time or resources are implicit costs. Explicit costs include startup and operating costs if someone quits employment to establish a business. Implicit costs are the income and benefits workers could have earned if they kept working.
How can opportunity costs be calculated?
Opportunity cost is the difference between the projected returns of the best and chosen choices. In practice, this is difficult since it implies anticipating the future consequences of uncertain and complicated events. Opportunity costs can also include pleasure, enjoyment, and societal influence. To evaluate opportunity costs, one must identify and analyze each choice’s explicit and implicit costs and advantages and give suitable values. Estimating probabilities and magnitudes of outcomes may entail historical data, market research, surveys, trials, or other approaches. It may also include weighing factors subjectively or preferentially. An individual may value leisure time over income, while a firm may value social responsibility over profit.
How do opportunity costs affect business decisions?
Opportunity costs help businesses weigh trade-offs and alternatives. Opportunity costs may help a company enhance value generation and competitive advantage by optimizing resource allocation (O’Donnell, 2016). Opportunity costs can also assist in preventing the sunk cost fallacy, which involves investing in a losing project or activity instead of transitioning to a more profitable one.
Opportunity costs can influence various aspects of business decisions, such as:
Capital budgeting is the selection of how to fund long-term initiatives or investments. Opportunity costs can help compare the expected returns and risks of different projects and choose the ones with the highest net present value (NPV), which is the difference between the cash inflows and outflows (Opportunity Cost: Definition, Calculation Formula, and Examples, n.d.).
Production: involves transforming inputs into outputs. Opportunity costs can set the ideal output mix depending on each production unit’s marginal costs and benefits. A company may manufacture more of a product with greater marginal revenue than its marginal cost and less of another.
Pricing This is the process of fixing goods or service prices. Opportunity costs and demand and supply elasticity, which assesses consumer and producer responsiveness to price changes, can assist in establishing the appropriate price. A company may charge a higher price for a product with low demand elasticity, indicating buyers are not sensitive to price fluctuations, and a lower price for a product with strong supply elasticity, suggesting producers may easily raise or reduce output.
An example of opportunity costs in a business decision
Imagine a fictional company that is facing a decision about whether to enter a new market or not. To show how opportunity costs influence business choices, the company has two options:
Option A: A new market opportunity has emerged but needs a large upfront investment of $10 million. The projected return is $2 million per year for a decade.
Option B: Remain in the current market, which has no upfront cost and is expected to generate $1.5 million annually for a decade. The trade-off of each option is measured by comparing their expected earnings and adjusting them to their present values by 10%. The company could make more money by putting its funds in a bank account or bond that pays the same interest rate. The present value of an option is the sum of the yearly net incomes after discounting.
The present value of option A is:
PV(A) = $2 million / (1 + 0.1) + $2 million / (1 + 0.1)^2 + … + $2 million / (1 + 0.1)^10
PV(A) = $12.28 million
The present value of option B is:
PV(B) = $1.5 million / (1 + 0.1) + $1.5 million / (1 + 0.1)^2 + … + $1.5 million / (1 + 0.1)^10
PV(B) = $9.21 million
Option A’s opportunity cost is the difference between option B’s current value and its original investment:
OC(A) = PV(B) – $10 million
OC(A) = -$0.79 million
The opportunity cost of choice B is the difference between option A’s present value and original investment:
OC(B) = PV(A) – $10 million
OC(B) = $2.28 million
Option A is cost-wise better than option B since it sacrifices less value. Option A creates greater value than option B due to its larger net present value. Therefore, the corporation should select option A and enter the new market.
Conclusion
Opportunity costs are the gains lost by selecting one choice over another. They assist in analyzing trade-offs and alternatives in each decision. One may optimize value generation and competitive advantage by efficiently considering opportunity costs and using scarce resources. Comparing predicted profits and subtracting expenses of the chosen alternative yields opportunity costs. Opportunity costs impact capital planning, production, and price. Business decisions like expanding to a new market involve opportunity costs, which are the difference between the alternative choice’s current value and the chosen option’s initial expenditure.
References
Khan Academy. (2019). Lesson summary: opportunity cost and the PPC. Khan Academy. https://www.khanacademy.org/economics-finance-domain/ap-macroeconomics/basic-economics-concepts-macro/production-possibilities-curve-scarcity-choice-and-opportunity-cost-macro/a/lesson-summary-opportunity-cost-and-the-ppc
O’Donnell, R. (2016). Complexities in the examination of opportunity cost. The Journal of Economic Education, 47(1), 26–31. https://doi.org/10.1080/00220485.2015.1106368
Opportunity Cost: Definition, Calculation Formula, and Examples. (n.d.). Investopedia. https://www.investopedia.com/terms/o/opportunitycost.asp#:~:text=Opportunity%20cost%20represents%20the%20potential
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