Every day, business leaders like you and me make decisions: one choice over another. Most of the time, the potential trade-offs are clear, and we know what to do intuitively. Sometimes it’s not so simple.
If you don’t know the actual cost of a critical business decision, that’s not an investment; it’s gambling. You must know the difference, especially in a business culture that champions speed and risk.
Opportunity cost refers to the potential benefits one could have received by taking an alternative action.
Opportunity cost compares the potential benefits or profitability lost when choosing between different options. When you spend any resource on one thing—capital or human resources—less of it is available for other pursuits. That’s what opportunity cost is in a nutshell.
Let’s go a little deeper and look at the two most important considerations in opportunity cost.
Explicit costs are easily quantifiable expenses associated with a decision.
For instance, if a business owner invests heavily in product development, he has made a decision that comes with explicit costs: research, materials, design, logistics, and manufacturing. Other direct costs might include application fees or interest on loans.
If a cost is explicit, it’s quantifiable. It’s a number.
Implicit costs are expenses that are difficult to quantify.
If the same business owner we discussed above allocates the bulk of his budget to product development instead of marketing, he incurs implicit costs. Here are some examples:
- The marginal cost of not expanding the product line.
- The time you can’t spend on other goals.
- Spending money that could produce a better or faster ROI.
- The sunk cost of any projects you may have to defund.
Calculating opportunity costs helps us assess the risks and rewards inherent in every business decision. By framing our decision-making process within the context of opportunity cost, you’re setting yourself up for responsible decision-making.
How do you calculate opportunity cost accurately?
The opportunity cost formula is straightforward: the return on the best-forgone option minus the return on the chosen option.
However, effectively applying this formula requires a deep dive into explicit and implicit costs. It involves using mathematical formulas and accounting software to assess potential benefits and drawbacks, thereby efficiently estimating returns under a variety of scenarios.
First, evaluate the feasibility of the opportunity.
You want to consider all potential risks and opportunities from a practical perspective. Consider tangible and intangible costs such as the following:
- Cash flow and the cost of servicing debt or delaying investments.
- Employee competence and capacity
- Customer needs.
- Leadership capacity.
- Your risk tolerance and margin for error.
Second, quantify the total cost of acting on the opportunity.
The total cost of taking action includes not only the explicit monetary costs involved but also the implicit costs:
- Time
- Effort
- Employee training
- Regulation and compliance
- Failing to capitalize on a profitable trend
- Stakeholder confidence
- Other unique resources required to take advantage of the opportunity
It’s important to note that sunk costs, or money that has already been spent and cannot be recovered, do not factor into the total cost of acting on an opportunity.
Third, compare the future value of acting on the opportunity with the cost of refusing the opportunity.
Assess the potential benefits of acting on this opportunity, such as:
- Increased revenue in the near and long term.
- Expanded brand recognition.
- Enhanced competitive positioning.
There is a cost for refusal, just like there is a cost for action. The long-term cost of not acting on the opportunity includes the potential financial costs and any potential negative impact on the organization’s reputation or competitive position.
By carefully weighing both the potential benefits and costs associated with an opportunity, including the marginal opportunity cost, decision-makers can make more informed choices about how to proceed.
When learning how to calculate opportunity cost, examples from the real world serve as good guides.
Netflix’s decision to focus on streaming is a classic example of a successful opportunity cost analysis.
In the mid-2000s, when shifting its business model from DVD rentals to streaming, Netflix faced a significant opportunity cost decision.
- Explicit Costs included direct investment in digital infrastructure and licensing content.
- Implicit Costs included the potential loss of brand recognition in the DVD rental industry, which was still profitable at the time.
Netflix calculated its decision to capitalize on the shift in consumer preferences toward digital content, and it paid off. The takeaway? Weighing the potential future benefits against the immediate costs and lost revenue from an existing business line can lead to transformative growth and market leadership.
A small business owner decides whether to open a new coffee shop in an upscale downtown area or a high-traffic suburban mall.
- Explicit Costs may be higher rent and operational costs in the downtown area.
- Implicit Costs may manifest in lower brand prestige because the value of the coffee is connected to location and social class.
The business owner conducts a thorough market analysis. He considers the brand alignment with location and long-term growth potential.
Finally, let’s consider a tech startup trying to decide whether to prioritize employee training or immediate product upgrades in this quarter’s budget.
- Explicit Costs may be the immediate costs for training programs or development work on the product.
- Implicit Costs may be potential market opportunities lost if the product upgrade is delayed compared to the possible long-term benefit of a better-trained workforce.
The startup evaluates how each option aligns with its strategic goals—short-term market competitiveness or long-term operational efficiency. It then calculates whether to invest in comprehensive employee training, betting on increased productivity and innovation to provide higher yields in the long term.
It is reasonable to conclude that, due to the investment in human resources, product upgrades funded next quarter could come faster and cost less.
Are you ready to optimize your business decisions?
I often find that business owners feel pressure to handle every little detail themselves. However, successful leaders make informed decisions, delegate, and seek professional advice. Understanding opportunity cost, especially in tax considerations and investment decisions like those in the stock market, lets you optimize business decisions and capital structure.
If you need a partner to help you strategize and understand the full scope of opportunity costs in your business decisions, I’m here to help. Schedule a discovery call today.
Talk soon,
Jeremy A. Johnson, CPA