How to calculate...
How to calculate opportunity cost for each business decision.
Working with limited resources is one of the challenges that entrepreneurs must learn to love. There’s no shortage of pricing strategies and economic theories to create harmony out of a tight business budget. But as more opportunities arise to spend, save, or invest, you need a clear-cut method of comparing your choices. You need to determine the opportunity cost.
Put simply, opportunity cost is what a business owner misses out on when selecting one option over another. It’s a way to quantify the benefits and risks of each option, leading to more profitable decision-making overall.
This article will show you how to calculate opportunity cost with a simple formula. We’ll walk through some opportunity cost examples and give you tips to apply them to your business. You’ll also learn how opportunity costs, sunk costs, and risks are different.
The definition of opportunity cost.
In economics, opportunity cost is a fundamental concept. It’s the idea that once you spend a resource on something, you can’t spend it on anything else.
In business, the same logic applies. Opportunity cost represents the cost of a foregone alternative. In other words, it’s the money, time, or other resources you give up when you choose option A instead of option B. The goal is to assign a number value to that cost, such as a dollar amount or percentage, so you can make a better choice.
You can also think of opportunity cost as a way to measure a trade-off. Individuals, investors, and business owners face high-stakes trade-offs every day.
Entrepreneurs need to figure out which actions to take to get the best return on their money so they can thrive and not just survive. That action might mean hiring a marketing director for $80,000 per year or investing in marketing automation software for $3,000 per month, depending on the opportunity cost.
Opportunity cost can be positive or negative. When it’s negative, you’re potentially losing more than you’re gaining. When it’s positive, you’re foregoing a negative return for a positive return, so it’s a profitable move.
Whether it’s an investment that didn’t go to plan or marketing software that didn’t improve lead quality, no one likes to see money disappear. Next, let’s look at the opportunity cost formula to see how entrepreneurs analyze each trade-off.
How to calculate opportunity cost with a simple formula.
The opportunity cost formula lets you find the difference between the expected returns (or actual returns) for two different options. This formula is helpful in two different scenarios: You can use it to estimate the impact of an upcoming decision, or you can calculate the losses or gains of past decisions.
Use this simple formula to calculate opportunity cost for a potential business investment:
Opportunity cost = Return on option A – Return on option B
The more you can inject real data — like market-rate salaries, average rate of return, customer lifetime value, and competitor financials — into your projection, the better. In most cases, it’s more accurate to assess opportunity cost in hindsight than it is to predict it.
If you’re performing a cost analysis for a past investment, the formula stays the same but the labels change slightly:
Opportunity cost = Return on option not chosen – Return on chosen option
Keep in mind that, whether a business owner, accountant, or seasoned investor is running the numbers, there are some limitations when calculating opportunity cost. While the formula is straightforward, the variables aren’t always. It isn’t easy to define non-monetary factors like risk, time, skills, or effort.
For example, the three weeks you spend recruiting and interviewing a marketing director is time you can’t spend tinkering with a new product feature. As a result, it’s not always a question of, “How is this money best spent?” Sometimes, the more relevant question is, “Which option gives me the comparative advantage?”
Next, we’ll look at this formula in action.
Two opportunity cost examples.
Opportunity cost describes the difference between the value of one alternative and the value of the next best alternative. Below, we’ve used the formula to work through situations business founders are likely to encounter.
Here are some simple examples of opportunity cost.
Scenario #1: Big savings.
Let’s say you’re trying to decide what to do with $11,000 in retained earnings. You’re thinking of stowing your funds in a business savings account, and there are two standout options.
One certificate of deposit (CD) with a major bank offers an annual interest rate of 3.5% compounded monthly. Using an interest calculator, you determine that your savings would grow to $13,100.37 in five years, an increase of over $2,000. The trade-off, however, is that you can’t withdraw these funds for the entire five-year period.
On the other hand, a cash management account (CMA) offers an annual interest rate of 3%, compounded monthly. Over five years, your $11,000 would grow to $12,777.78, an increase of nearly $1,800. But, you can freely transfer funds.
Now, we plug these variables into the formula:
Opportunity cost = Certificate of deposit – Cash management account
= $13,100.37 – $12,777.78
The purely financial opportunity cost of choosing the CD over the CMA is $322.59 in earnings. But you also need to consider the liquidity of your savings. Although you’d earn more with a CD, you’d be locked out of your $11,000 and any earnings in the event of an emergency or financial downturn. As a result, you choose the CMA.
Scenario #2: Investor dilemma.
An investor is interested in purchasing stock in Company A or Company B.
The expected return on investment for Company A’s stock is 6% over the next year. It’s in a stable industry environment with no short- or long-term threats.
Company B’s stock is expected to return 10% over the next year. Proposed industry regulation is threatening the company’s long-term viability, but the law is unpopular and may not pass.
Now, we plug these variables into the formula:
Opportunity cost = Company A – Company B
= 6% – 10%
The opportunity cost is a difference of four percentage points. In other words, if the investor chooses Company A, they give up the chance to earn a better return under those stock market conditions. Although some investors aim for the safest return, others shoot for the highest payout. This investor selects the riskier option.
As you can see, the concept of opportunity cost is sound, but it isn’t the end all, be all for a discerning entrepreneur. That said, the opportunity cost formula is still a useful starting point in a variety of scenarios.
Capital structure and opportunity cost.
Business owners need to know the value of a “yes” or “no” to each opportunity. This is particularly important when it comes to your business financing strategy.
Capital structure is the mixture of the debt and equity a company uses to fund its operations and growth. Knowing how to calculate opportunity cost can help you better approach your capital structure.
You can determine whether it makes more fiscal sense to pay down your loan balance, launch a new product, or accept even more financing.
Opportunity cost vs. sunk cost.
Sunk cost refers to money that has already been spent and can’t be recovered. Opportunity cost, on the other hand, refers to money that could be earned (or lost) by choosing a certain option.
For example, you purchased $1,000 in new equipment to manufacture backpacks, your number one product. That is a sunk cost. Later, you think that you could have funneled that $1,000 into an ad campaign and won 30 new customers. If you determined the difference in revenue generated by each of those two scenarios, you’d be able to find the opportunity cost.
Opportunity cost vs. risk.
Although the “cost” and “risk” of an action may sound similar, there are important differences. In business terms, risk compares the actual performance of one decision against the projected performance of that same decision. For instance, Stock A ended up selling for $12 instead of $8 a share.
Opportunity cost compares the actual or projected performance of one decision against the actual or projected performance of a different decision. Continuing the above example, Stock A sold for $12 but Stock B sold for $15.
Is it worth it?
Learning how to calculate opportunity cost is an essential skill for all business owners. The result won’t always be a concrete number or percentage, but it can offer important insights into the trade-offs you’ll face every day.
When you have limited time, money, and resources, every business decision comes with an opportunity cost. Rest assured — you’ve made a good investment by reading this article.
Brex for startups.
Get global corporate cards, ACH and wires, and bill pay in one account that scales with you from launch to IPO.