Opportunity cost: Definition & how to calculate it

Opportunity cost is the value of the next best option you miss out on when you make a choice. It's like choosing between two jobs: you take one, but you lose the potential earnings and benefits of the other.

A key fundamental aspect of operating a business is evaluating business decisions—from financial planning and strategy to operational efficiency. Using the opportunity cost formula can help provide valuable insight into what you stand to gain—and what you stand to lose.

The fundamentals of opportunity cost

To understand what opportunity cost is, you must understand its key components:

• Scarcity: In business, resources like time and money are limited—evaluating choices means looking at the trade-offs that you’ll face when making certain decisions.
• Trade-offs: In decision-making, you explicitly choose one option, including all gains and losses. This process means you’ll make trade-offs between the two options, but ultimately, your best option will win.
• Value of the best runner-up: Most business decisions come down to two choices: A or B. Opportunity cost is the value of the best option not chosen compared to the value of the option you chose.
• Explicit and implicit costs: Opportunity cost comprises two cost factors: explicit and implicit costs. Explicit costs are those that directly revolve around money or cash outlay. Implicit costs are nonmonetary losses, like time spent or lost resource opportunities.

Calculating opportunity cost: Methods and formula

Since opportunity cost is essentially the cost of giving up one thing for another (for business executives, it’s generally making one business decision over another), it’s essential to know how to calculate opportunity cost in business.

The basic opportunity cost formula is:

Opportunity Cost = Best Foregone Option's Value - Chosen Option's Value

To calculate your opportunity cost with the basic formula:

• Clearly identify your available choices, narrowing them down to one option and one best alternative option.
• Explore both the explicit and implicit values related to each option.
• Subtract the value of your chosen option from the value of the option not chosen. The result is the opportunity cost.

In business, where the decisions are more complex than a simple one-dimensional value, it’s important to consider both the long-term explicit (or money) factors and the long-term implicit (or nonmoney) factors. This can include potential returns, costs, benefits, time spent, or resources needed.

Limitations with opportunity cost formula

While there are many benefits to calculating opportunity costs for making business decisions, especially at the executive level, some limitations exist. These include:

• Making subjective assumptions, especially regarding intangible benefits (increased brand reputation, for example) or future financial outcomes.
• Having multiple options that could be the true next-best choice or not considering options that haven’t been brought to light yet.
• Calculating opportunity cost involves using somewhat limited information, like future returns, to predict the resulting losses.
• Business decisions are often quite complex and involve financial, social, and legal considerations. Identifying and quantifying all aspects of an option or opportunity to use the formula correctly can be challenging.

Ways to evaluate the opportunity cost

Once you’ve calculated opportunity cost, you can use various methods to evaluate your results to help your decision-making process. Some ways of considering opportunity cost include:

• Sensitivity analysis, where you can identify the critical factors that make the biggest impact and vary assumptions to see how that changes the effect of your decision-making.
• Real-option analysis, where executives can use decision trees to visualize how different options can change future business outcomes.
• Evaluating flexibility by considering how each option can change over time (expanded, contracted, or abandoned).
• Cost-benefit analysis, where the costs and benefits of each option are listed and given a monetary value, then the net present value (or NPV) is evaluated, considering the time value of money.
• SWOT analysis, where executives weigh in on the strengths, weaknesses, opportunities, and threats when evaluating the tradeoffs that will undoubtedly occur.
• Scenario-planning, where executives plan out several scenarios (optimistic, pessimistic, and most likely to happen) and evaluate how each possible option would perform.
• The use of software and applications for opportunity cost calculations to help your decision-making.

Using multiple ways of evaluating opportunity cost can help you see the “big picture” when it comes to the alternative option not chosen, reaffirming if your decision was indeed the best.

Opportunity cost examples

There are plenty of simple real-world examples to calculate opportunity costs, like choosing whether to spend or save birthday money. However, opportunity costs in business are much more complex, dealing with several nuanced implicit factors.

Some examples of opportunity costs in business include:

• Investment decisions, where you might choose between investing in a new product or expanding an existing successful one. Here, the opportunity cost is the potential return you’d stand to gain from the unchosen option.
• Resource allocation can include increasing inventory carrying costs heavily for one product or increasing production for one product, which would decrease the money or output for the other product.
• Time management, both from the standpoint of management time and employee time. Choosing which project an employee should work on will dictate that they do not work on the other. The same is true for management, where spending time on one specific function takes away time from other vital tasks.
• Market entry, where pulling resources to enter a new market could potentially divert resources from the existing, thriving markets.
• Mergers or acquisitions, where acquiring the wrong company at the wrong time, could prevent you from acquiring a more desirable company with higher profit potential.
• Business pricing, where deciding on costs, like handling fees, could be the difference between gaining customers and losing them.

Opportunity cost vs. profit analysis

While opportunity cost and profit analysis are excellent tools for guiding business decisions, they are two distinct tools that provide different information.

Opportunity costs are used to evaluate the true cost of a decision, whereas profit analysis determines the financial viability of a business choice. Where profit analysis digs deep into the larger image of the profitability of a chosen decision (including identifying the NOPAT), opportunity cost only looks at what was lost by not choosing an option.

Tips for minimizing negative opportunity costs

In the big picture, businesses would prefer positive opportunity costs, where you’d forego a negative return for a positive one, making the decision profitable. However, there are some situations where you’ll end up with negative opportunity costs and potentially lose more than you stand to gain.

To help minimize negative opportunity costs:

• Plan strategically by prioritizing high-value initiatives and scheduling regular business strategy reviews.
• Review resource allocation to identify bottlenecks and optimize resource utilization.
• Optimize financial management workflows, like investment prioritization and risk management.
• Improve operation efficiencies by adopting new technologies and tracking performance measurement.
• Invest in human capital management by fostering a healthy employee engagement culture and succession planning.

These safeguards can help you make better decisions and avoid costly mistakes, such as investing in projects that don't yield returns or misusing valuable resources. This is a big part of strategic cost management.

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