The importance of opportunity cost can't be understated. It helps you be more confident in your decisions, knowing that you're choosing the best options for your business.
In this guide, you'll learn how to calculate opportunity costs, the different types and some real-life examples.
What is opportunity cost?
An opportunity cost lets you calculate what you're giving up when you choose one option over another — these can be hard costs you need to cover or the opportunity to generate income or benefits from alternative uses of resources, time and money.
What can opportunity cost tell you?
Opportunity costs can tell you more about the pros and cons of your available options so you can make a more informed decision.
Why is opportunity cost important?
Opportunity costs are important to consider because they'll help you use your limited time, money, space and other resources to the best advantage.
Explicit vs implicit costs
Explicit and implicit costs help you understand the opportunity cost of each option.
Explicit cost
Explicit costs have a dollar value – they're traditional business expenses. For example, if you're comparing two storage facilities, you'll consider explicit costs like rent, outgoings, fit-out and staff parking.
Implicit cost
Implicit costs are more intangible and let you consider what you'd gain or lose by using your time and resources differently.
For example, if one storage facility is cheaper but further from your main office, you should consider the implicit opportunity cost of increased travel time.
While implicit cost isn't a direct cash outlay, it represents a lost income opportunity. With an out-of-town storage facility, you may end up paying for your team to sit in traffic rather than spending their time on client relationships, potentially impacting retention and sales.
How to calculate opportunity cost
To calculate opportunity cost, you'll need to uncover the implicit and explicit costs to determine the real return of each option. Once you've got these figures, calculate the opportunity cost of your preferred option using this formula:
Opportunity cost = return (or cost) of alternative option - return (or cost) of chosen option
Opportunity cost examples
Here are some examples of how you might use opportunity cost calculations in your business decision-making.
Introducing a new product line
Say you're planning to introduce a new product line into your range. You need to consider the cost of developing the product and how you'll fund it.
Suppose this money will come from your yearly marketing budget, and you'll need to factor in a possible drop in revenue. You can calculate the opportunity cost of launching your new product like this:
Opportunity cost of expanding your range:
Explicit costs: $100,000 for product development
Implicit costs: $45,000 potential loss in revenue from a drop in marketing budget
Total cost: $145,000
Opportunity cost of not expanding your range:
Explicit costs: none
Implicit costs: $500,000 loss in potential revenue in new product over ten years
Total cost: $500,000
$500,000 (potential earnings lost over 10 years) – $145,000 (product development cost + lost sales) = $355,000 over ten years (or $35,500 annually)
This calculation tells you that the opportunity cost of not expanding your range will be $355,000 over ten years or $35,500 annually.
Leasing an espresso machine
You're thinking about introducing an espresso machine to the office instead of paying for flat whites at your local cafe.
You need to consider explicit costs, like leasing the machine, and the implicit cost of the time your staff will spend making the coffee.
You should measure this against the explicit costs of the cafe-coffee option, that is, buying the flat whites.
The cafe option's implicit cost is the time staff spend going to and from the cafe to buy rounds of coffee for colleagues and visiting clients. Here's how you calculate the opportunity costs.
Opportunity cost of buying cafe coffees, assuming the following:
Your team buys an average of 400 coffees per month, which cost around $5 each.
On average, team members will buy four coffees per trip to the cafe, with each trip taking 15 minutes. Your more junior staff tend to go to the cafe, and their average hourly rate is $50.
Explicit costs: $5 coffee x 400 = $2,000/month
Implicit costs: 15 min cafe trip x 100 = 1500 minutes or 25 hours
25 x $50 average hourly rate = $1,250/month
Total cost: $3,250/month
Opportunity cost of purchasing an espresso machine, assuming the following:
It takes about 6 minutes to make each coffee on the new machine, and again, junior staff will do this at an average hourly rate of $50.
Explicit costs: $250 per month lease + $120 coffee, sugar milk per month = $370/month
Implicit costs: 6 mins per coffee x 400= 2400 minutes or 40 hours/month
40 x $50 average hourly rate = $2,000/month
Total: $2,370/month
$3,250 (cost of cafe coffees) – $2,370 (cost of coffee machine) = $880 monthly opportunity cost
The opportunity cost of sticking with cafe coffees is $880 a month, making the coffee machine the smarter financial option.
Discounting your inventory
It's after the summer wedding rush, and you've $10,000 worth of decorations left.
To save on carrying costs and help avoid cash flow problems, you could discount the inventory by 30% to encourage sales.
The alternative is to keep the inventory until you can sell it at full price again. The start of the next wedding season is in 12 months — if you hold the stock, it will cost you $250 a month.
You'll also need a business loan of $7,000 to cover your operating expenses at an annual interest rate of 15%. Here's how you might calculate the opportunity costs:
Opportunity cost of discounting stock by 30%:
Explicit costs: 30% of $10,000 = $3,000
Implicit costs: none
Total cost: $3,000
Opportunity cost of carrying the stock:
Explicit costs:
Inventory costs (storage) $250 x 12 months = $3,000
15% interest on $7,000 for 12 months = $1050 interest*.
The cost of the loan would be principal + interest = $8050
Implicit costs: none
Total: $11,050
$11,050 (hold stock) – $3,000 (sell with discount) = $8,050
This shows that holding the stock will have an opportunity cost of $8,050, so discounting is a better financial decision.
*This assumes simple rather than compound interest.
Opportunity cost vs sunk cost
Opportunity cost is different from sunk costs.
Opportunity cost is a way to compare the financial outcomes of one option with another.
A sunk cost is money you've spent on a project or initiative you can't get back.
Say before considering changing to an in-house coffee machine, you've already spent $400 buying your staff reusable cups for coffees from the cafe.
The cost of reusable cups is a sunk cost and shouldn't factor into your decision about whether or not to lease an espresso machine.
This is important to remember — sunk costs can sometimes cloud people's judgement. Since you've already invested money into the cafe option, it can feel as though it would be a waste to lease the machine.
Opportunity cost vs risk
Opportunity cost needs to be weighed against risk.
How certain are you of your demand forecasting?
Do you think your product will sell as well as you expect?
Have you considered other factors that could impact your calculations?
For example, by introducing a coffee machine, you risk increasing overall consumption at your office — how do the figures stack up if your people drink two cups of coffee daily instead of one?
Opportunity cost FAQs
Can opportunity cost be negative or positive?
Opportunity cost can be positive or negative.
A negative number indicates that your chosen option makes less financial sense.
For example, if your office started consuming 800 cups of coffee a month with the convenience of a self-service coffee machine instead of your predicted 400, the opportunity cost becomes a negative number.
6 mins per coffee x 800 coffees = 4800 minutes or 80 hours
80 hours x $50 hourly wage for junior staff = Implicit costs $4,000
Explicit costs - machine lease, plus doubled coffee, milk and sugar costs = $490/month
Total costs of x 800 in-house coffees (implicit + explicit costs) = $4,490
$3,250 cafe cost ﹣ $4,490 in-house cost = ($1,240) negative opportunity cost
The negative opportunity cost tells you that, in this case, it's more cost-effective to keep buying at the cafe as it reduces overall consumption of coffees and the total cost to your business.
Does opportunity cost need to be monetary?
Opportunity costs don't need to be monetary, but — as with implicit costs — to be included in a calculation, you need to be able to assign a monetary value.
Why are opportunity costs often overlooked?
Opportunity costs are often overlooked because they refer to future and potential earnings or opportunities.
These are less tangible than the real, immediate pain of losing sales or discounting products. Opportunity costs are a way of comparing options more analytically.
Make decisions with all the data
Understanding the explicit and implicit costs of each decision you make will let you calculate and consider the opportunity costs of each option.
To get started with calculating your opportunity costs, you need good data.
That's where real-time financial information from MYOB Business can help. Get started today.
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