Opportunity cost definition
Opportunity cost is a benefit and risk analysis that determines how actual outcomes compare to the best possible outcome for alternative choices. It represents the potential to earn money, while cost refers to money not made because of a poor choice. The simplest example is if someone chooses between investing in two stocks and selects the one that underperformed.
The difference in return is your opportunity cost. It’s possible to receive a return on investment and still experience an opportunity cost. It’s important to note that nobody has a crystal ball that can accurately predict the potential yield of every decision your management team makes, but you can use opportunity cost to learn from past mistakes.
How to calculate opportunity cost
You can calculate opportunity cost using a simple formula. Determine what your return on investment might have been when making a different decision. Compare it to the decision you actually made and subtract the real gain from the alternative choice’s potential gain. Using the example of stock investment, if investing $10,000 in one stock gave you a $5,000 gain compared with a $7,500 gain if you’d chosen a different stock, your opportunity cost is $2,500.
What is an example of opportunity cost in business?
Where you invest your money isn’t the only factor to consider when determining opportunity cost. Opportunity cost examples in business include:
Forgoing equipment maintenance
In an effort to reduce overhead, managers make the decision not to invest money in repairing or replacing equipment at their production facility. The equipment breaks down and is taken out of service until it can be fixed or replaced. The bill for replacing the equipment is higher because it wasn’t properly maintained. There is an opportunity cost due to lost productivity and higher repair costs.
Poor inventory management
A business doesn’t accurately predict demand for a popular product. Instead of committing enough space in inventory for the best-selling product, the business occupies that inventory space with a product that underperforms. The opportunity cost is represented in lost sales due to the inventory shortage and the costs associated with holding the poor-selling product instead.
Store closed during peak hours
A business closes its doors every day at 7pm, but further analysis determines a lot of people shopping at similar stores make purchases between 7pm and 8pm. Keeping the store open an extra hour could result in enough sales to justify paying employees for another hour, and there’s an opportunity cost. This scenario can be reversed if the store keeps its doors open during unpopular hours and needs to pay staff despite slow sales.
Explicit vs. implicit opportunity costs
Most opportunity costs fall into two categories. Explicit opportunity costs represent lost capital due to direct expenditures, such as choosing one product vendor over a cheaper alternative or paying more for office space, manufacturing and shipping. Spending more money on these things doesn’t always create an opportunity cost, especially if investing in higher-quality materials or leasing a more expensive building in a high-traffic location drives more sales, so bear this in mind when calculating your opportunity cost.
Implicit opportunity costs are losses associated with poor decision-making. If you commit your staff’s time to pursue a fruitless objective, for example, you suffer an opportunity cost when they could have generated a greater return from a different project. The choice to close a store an hour earlier represents an implicit opportunity cost, for example.
Why opportunity cost is important
Your company’s leadership team doesn’t have a crystal ball, but hindsight is much more accurate than foresight. If you made a decision that didn’t have the outcome you’d hoped for, you can use opportunity cost evaluations to see exactly where you went wrong. This helps you make effective choices based on what you’ve learned.
When you’re evaluating your company’s opportunity costs, you can also determine which choices gave you great returns on investment so you can maintain the course. Opportunity cost impacts all facets of your company, too, from how you manage inventory to your recruiting and onboarding strategies.
How to apply opportunity cost to personnel decisions
How you recruit and manage your workforce can impact your returns, so you should review your hiring and training processes to see if they’re as effective as you’re hoping. Some factors to consider include the following:
Hiring and contracting workers
Some roles within your organization need to be filled by full-time employees, but many businesses bring on new employees they could be contracting instead. One traditional example is the pay structure for sales representatives. Many sales representatives are considered independent contractors and only receive payment if they make sales.
If you’re offering your sales staff an hourly wage or salary in addition to commissions on their sales, you should consider whether the extra expense is worth it. If you hire an accountant to run payroll, assess your tax liabilities and run inventory, determine whether it may be more cost-effective to outsource these tasks to an accounting firm instead.
Every full-time employee costs more to employ than a contractor because you need to offer benefits. You should only fill roles that you can’t contract to other firms, which are responsible for providing their contractors with benefits instead.
Recruiting strategies
How effective are your recruiting strategies? If you have high turnover among new employees, you may not be hiring the right candidates, or something in your onboarding process is broken. Ineffective recruitment practices represent an opportunity cost because the money you invest in people that underperform or move on to positions at different companies is lost.
You may need to invest more in training and mentoring initiatives upfront but could reap a better return on investment when your retention rates increase and new hires succeed in their roles. If you’re looking to attract top-tier talent, you may wish to evaluate your pay structure and benefits package to make your business more attractive to top producers.
Training and promotions
Offering your current employers continued training can make them more productive and give you a return on your investment. If you notice a minimal change in productivity after providing training, you’re losing money on your training initiatives. Promoting the wrong people or offering them a promotion at the wrong time can also represent an opportunity cost.
Benefits packages
Offering great benefits packages is one way companies lure talent, but it comes at a cost to your business. One way to determine whether your benefits are considered an opportunity cost is to evaluate if you can maximize the tax advantage of offering benefits like HRAs and paid leave. Offering popular benefits that reduce your overhead can save you a ton of money while still keeping your employees happy and healthy.
Frequently asked questions about opportunity cost
What is the difference between money cost and opportunity cost?
Plainly put, money cost is defined as your business expenses, such as what you pay for rent, supplies, wages and inventory management. Opportunity cost is money you could’ve earned if you made a different decision.
Can you ever benefit from opportunity cost?
Opportunity cost is normally viewed as a financial loss due to making one decision instead of another. The long-term impact of your choices may reduce or exacerbate the impact of your choice. For example, if your choice resulted in greater customer satisfaction and drove increased sales, the impact is minimized.
Could opportunity cost be applied to personal finances?
Yes! Everyone makes decisions that may result in a financial gain or loss, such as using a cash windfall to save money, refinancing a home or auto loan when interest rates are right or making important spending decisions. Opportunity costs can impact businesses and individuals in similar ways.
