Business owners must regularly make decisions about which opportunities to pursue.
For example, you might have to make a choice between investing in a new production line or recruiting more staff. Understanding opportunity cost can help make those tough decisions a little easier. In this article, we'll dive into the concept of opportunity cost, how it guides business decisions, and how to calculate it.
What is an opportunity cost?
In its simplest terms, an opportunity cost is the lost value from not doing something in favour of the next best alternative option. Every decision is a trade-off, and the opportunity cost is what you give up for what you gain. In that sense, you always want to keep the opportunity cost as low as possible.
In a business context, using the example given previously, investing in a new production line might not deliver a return as quickly as, for example, recruiting more sales staff. If, however, the new production line offered a greater total return on investment than the new staff in the long term, then it could be argued that this makes more business sense as the opportunity cost of recruiting sales staff is lower.
How opportunity cost works
When it comes to using opportunity cost as a decision-making tool, business owners can use it for identifying the courses of action where they have the most to gain and least to lose.
“In a difficult trading environment, shareholders may look and decide a company will be in trouble in two years’ time if it doesn’t make changes,” says Matthew Hector, Senior Manager at Price Bailey, an accountancy and business advisory firm. “They might draw up three different plans of action and ask the financial director to work out the opportunity cost of each one.”
When considering the meaning of opportunity cost it is worth remembering that every action has such a cost associated with it – even doing nothing. Every day a vehicle manufacturer continues to use its factories to make motor cars, it loses out on the value of selling that real estate. But it calculates that the opportunity cost is far higher from selling up and stopping production.
Opportunity cost example
Hector gives the example of a business selling stationary and trying to decide whether to introduce a new range of pencils or move into staplers.
“It might be cheaper to buy 1,000 pencils than the same number of staplers, it might take up less storage space, but then the staplers might have a higher profit margin and you might anticipate greater demand,” he says.
“Ultimately you need to consider everything and come up with a predicted profit level from each venture over a set time period. If pencils would make you £200,000 against £100,000 for staplers, the opportunity cost of choosing staplers is greater, so you should buy and sell pencils.”
How to calculate the opportunity cost
By calculating as accurately as possible the potential or expected value of taking each option in front of your business, it is possible to see which has the lower opportunity cost associated with it.
Opportunity cost formula
Opportunity cost = returns on foregone option - returns on chosen option
Calculating opportunity cost requires a consensus of opinion, based on as much data and expertise as possible, of what the returns would be on a specific course of action over a set time period.
Dom Pope, head of digital marketing agency Own Your Space, says he constantly weighs up the opportunity cost of not working with potential clients as an initial outlay is generally involved before a profit is made.
“We charge a fee equivalent to 10% of what we spend on a client’s advertising,” he explains. “We are a small company and operate with some very big clients. They might look for us to pay a platform for advertising and then pay us a month later.”
Because the company has to pay for advertising before it is paid by its clients, and with different clients offering different expenditure and income profiles, Pope has to make informed decisions about which ones to take on.
Pope adds that cash flow concerns and the opportunity cost of losing new customers are the main reasons that Own Your Space has an American Express® Business Gold Card. The Card gives you up to 54 days to clear your balance, so you can keep your money in the account for longer and get more flexibility in your cash flow¹. You can also earn Membership Rewards® points² that can be spent with hundreds of retailers on items such as office supplies, IT equipment or employee perks.
Opportunity cost vs sunk cost
Opportunity cost analysis strictly looks at the future – what value can you grasp or lose tomorrow from actions you take today?
Sunk cost is concerned with the past. In economics, a sunk cost is a sum of money already paid or committed to that cannot be recouped.
For example, if a business spent £10,000 on a conference room for a strategy day that concluded the firm should open a new office, that is a sunk cost. It has gone and should be forgotten about. It certainly should not be taken into account when running a fresh calculation of the opportunity cost of opening that office versus expanding the current site.
When not to use opportunity cost
Opportunity cost analysis is an important tool for decision-making in business, but it isn’t infallible and it can’t be relied on in all circumstances.
By nature of being forward-looking, opportunity cost requires a lot of assumptions and predictions to be made.
“Using opportunity cost is good when you have fairly exact numbers you can feed in, and you know your market, your margin and so on,” says Hector. “For example, you wouldn’t have used it when deciding whether to go into personal protective equipment (PPE) manufacture at the start of the Covid-19 pandemic, as there were so many huge unknowns.”
Finally, an opportunity cost analysis is most useful when it comes to future spending decisions, but is less helpful if you need to cut existing business costs.
1. The maximum payment period on purchases is 54 calendar days and is obtained only if you spend on the first day of the new statement period and repay the balance in full on the due date. If you'd prefer a Card with no annual fee, rewards or other features, an alternative option is available – the Business Basic Card.
2. Membership Rewards points are earned on every full £1 spent and charged, per transaction. Terms and conditions apply.
