Have you ever had to choose between two options and were fearful of making the wrong choice?
You were likely considering the potential opportunity cost. This is an important concept in economics that considers the price of decision making and resource scarcity.
An important part of business strategy is understanding how much YOU can afford to lose in doing a particular thing. This is invaluable to a business owner because the hidden costs of not taking an action might be much greater than the expected future returns.
Opportunity cost is the penalty or financial cost when you take an action without regard to some future benefit that may result from the action. Dangerously, many companies look at these indirect costs in the wrong way. They might take an immediate action (for example, opening in a new location) without knowing all of the possible consequences.
Every decision you make involves some form of trade-off. This could play out in many ways.
At 18 years old, you may have made the decision to go to university or into full time work. You may have implicitly considered the implications of this financial decision. A degree could saddle you with debt for the next 10-20 years but provide you with increased earning power in the later part of your career.
This post will help you understand the concept of opportunity cost and how it applies to a wide variety of situations.
Opportunity cost formula
The opportunity cost calculation is fairly straightforward. It is a cost-benefit analysis of the estimated rate of return for each opportunity. The returns from the alternative choice are then subtracted from the option you choose.
Opportunity Cost = C1−C2
C1 = Return on best alternative option
C2 = Return on chosen option
Stock market example
For example, imagine you had the choice to invest in either Apple or Amazon 5 years ago.
- If you had chosen Amazon, you would have returned 390% of your investment over the past 5 years. Pretty good, eh?
- By comparison, Apple returned 463% over the same period.
- So, your investing decision resulted in a 73 percentage point loss in total gains.
From a company perspective, understanding what you could do and its implications can help you make better business decisions
If you have £35,000 in the bank and have the choice of three capital investments, which would you take?
1. Hire an extra employee for £35,000 a year. This employee could improve productivity and increase your profits by an extra £12,600 annually.
2. Invest £35,000 in software that streamlines your invoicing process and reduces costs by £45,500
3. Spend £35,000 on new office equipment, computers and furniture. This investment also increases productivity and reduces sickness absence thanks to more comfortable seating arrangements. The estimated cost savings come to £8,400
The expected return on investment (ROI) for each choice is:
- £12,600 or 36%
- £10,500 or 30%
- £8,400 or 24%
To work out the opportunity cost, you would substract the returns of your chosen option from the expected returns of the foregone alternative.
Put simply, if you choose to go ahead with options 2 or 3 you would be sacrificing 6 or 12 percentage points in returns. Multiply this by the hundreds of economic decisions business owners make each week and it stacks up to a lot of missed opportunities.
It is not just for financial decisions. Also consider the cost of time in your choices
Opportunity costs are not always shown in company financial reports. You should also consider implicit costs in how you use your time, and that of your teams.
A common example is diversification. Are you going to see better cash flow and profit by spreading resources among 50 customers or focusing exclusively on 5?
Also, consider resource scarcity and its impact on initiatives. If you implement concurrent projects to achieve the below all at the same time?
- Reduce wasted materials
- Deliver supervisor training
- Develop a strategy to enter new markets
What will be the hidden cost if your managers are spread too thin to make any of them a success? There are only a finite amount of hours in the week. If you have an Operations Manager working on all three initiatives, they may not have enough time to focus on making any a success.
Managing opportunity cost can help you deliver better projects by making the best use of the scarce resources available to you.
Famous examples of opportunity costs
The co-founder who sold Apple shares early
Ronald Wayne was the co-founder of Apple with Steve Jobs and Steve Wozniak. He helped start the company but instead quit and sold his 10% share back to the other business owners as he was too risk averse. The shares he sold for $800 would be worth over $100bn today.
FC Barcelona oust a legend who leads a rival to the league title
In Summer 2020, the Spanish football giant, Barcelona sold the prolific striker Luis Suarez to rivals Atlético Madrid. The reasons for his departure were a source of debate. He was possibly sold to cut wage costs or because he was deemed too old. The financial benefits of the sale are estimated to be around €12m in transfer fees and wage savings.
However, selling to Atlético strengthened a rival that ended up beating Barcelona to the La Liga title. A league that Barca have dominated for years. The missed prize money alone outweigh the small profit from the sale. The title winners received €158 million, while 3rd place Barcelona (last years winners) pocketed €115 million.
In 1867, Russia sold a great plot of land to the United States for $7.2m. Now know as Alaska, the territory was an economic liability to the Russians and they were keen to use it to pay off debt. The secretary of state who purchased the land, William Seward was criticised at the time.
The land was known as 'Seward's Folly' or 'Seward's Icebox' and ignored by the US for three decades. It was only the discovery of a major gold deposit in 1896 that justified Seward's actions. Alaska has proved a rich source of natural resources and contributed to the American boom in the 20th century.