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To make informed decisions, you need to understand and calculate opportunity costs. These figures help to highlight the gains and losses of your options, allowing you to make the most appropriate choice. Read our helpful guide explaining all you need to know about these costs and how you can benefit from them.
What Is Opportunity Cost?
Opportunity costs are the potential gains missed by choosing one option over another. It is the loss you take to make a gain, the price of a particular path at a fork in the road.
In these instances, you need to consider the other options’ value and weigh it against your choice. Every decision has missed opportunities, losses and gains. Therefore, they are present in every decision you make, no matter how small.
Why Is It Important?
Calculating the losses and gains of your decisions is crucial for distributing scarce resources. If you only have a limited amount of money or time to devote to a new venture, knowing the benefits and costs of every available opportunity will help direct your choice.
In Relation To Supply Chain Management
You can optimise your supply chain by working out these costs. Use them to calculate the potential gains and losses of your suppliers, storage, manufacturing and inbound and outbound logistics and choose the options that provide the highest ROI.
How To Calculate Opportunity Cost
There are a couple of ways of calculating these costs. Firstly, you can measure the benefits against each other to find the best solution. This process is subjective, and you may identify different benefits and losses to other people. Consider the upfront costs, the time and effort required, the running costs and the potential return.
On the other hand, there is an opportunity cost formula that you can use if you have monetary values for the benefits.
The Opportunity Cost Formula
Opportunity Cost = FO – CO
FO = return value of the missed option
CO = return value of the chosen option
Sometimes this equation will give you a low or negative value, meaning you chose the best option. For instance, you may choose a UK-based distributor that offers a potential return of £20,000 a year, over a European one that offers a return of £10,000 a year. This choice means your costs are -£10,000 a year and therefore the UK company is the best option.
To make this calculation, you need to understand your business overheads, turnover and profits as this will help you distribute your resources. Calculate your break-even point so you know how much you can afford to spend.
What Your Calculations Mean
These calculations inform a company’s strategy. They use them to consider the advantages and disadvantages of a decision so they can invest their time and funds to boost their business. Using the distributor example, the company would have £10,000 a year that could be used somewhere else or awarded to shareholders if they chose the UK-based option. However, the European alternative may have other non-monetary benefits, such as capitalising on a new market. These different losses can be split into Explicit and Implicit costs.
Explicit Costs
Explicit costs are the direct financial impacts of a decision. For example, if you own a restaurant and want to add a new item to the menu, it may cost £50 in ingredients, wages and equipment. The explicit cost is £50 that you could save or spend elsewhere.
Implicit Costs
Implicit costs do not represent a financial payment. They are the lost opportunities as a result of a decision.
An example of an implicit cost would be the losing opportunity to generate revenue from rent by choosing to live or operate in a property you own.
Opportunity And Sunk Costs
Sunk costs are the opposite of opportunity costs. It is money that has been spent in the past, as opposed to future costs. You may have bought a piece of equipment for £1000 and you use it for a service, that is a sunk cost. However, if it would cost you £1000 that could be used elsewhere for the equipment to start that service, that is an opportunity cost.
Real World Examples Of Opportunity Costs
Definitions and calculations can be hard to visualise. Here are a few, real-world examples:
A student may decide to study for an exam instead of going to the cinema with their friends. The cost is the ticket price and the enjoyment they would have had.
A commuter may choose to take the train to work instead of driving. This train journey takes an hour rather than a forty-minute drive, so the cost is twenty minutes on the way to work and twenty minutes on the way home.
Somebody may choose to buy a coffee for £5 every morning. The cost is the £150 a month that could be saved or invested to pay for something more expensive like a holiday or car.
Selling a new product might cost £500 a month in storage. The cost is £500 that could be spent improving another element of the business.
A farmer may choose to plant wheat in a field. The cost is the chance to plant corn or any other crop and the benefits it would have.
A lawyer, who makes £100 an hour, decides to go for a meal which costs £50 and takes 2 hours. The cost is 2 hours of work and the price of the meal is £250.
A business owns its office block and uses every space in it. If they decided to move or free up space for others to work there, they could rent out the office. The cost is the amount of profit they could generate by charging rent.
Key Takeaways
- Every decision has losses and gains, and missed opportunities
- Calculating these costs helps you understand the ramifications of each decision you make
- Different people will have varying losses and gains for the same decision
If you’ve calculated the opportunity costs of your new business venture, we can help you. At Breakwells, our logistics solutions deliver goods anywhere in the UK and the Channel Islands to help you reach your customers.
We ship and store items for your business, so you can take advantage of new opportunities and grow your operations. Contact us today to see how we can improve your logistics.
FAQ
What are opportunity costs?
Opportunity costs are the potential benefits missed by choosing one option over another. For example, if it costs £20 to go out to eat, the opportunity cost is £20 more than you could have spent on something else or saved.
Why are these costs important?
Calculating opportunity costs helps you understand the implications of your options and can inform your choice. It directs your decision-making with a cost-driven approach.
What is another name for opportunity cost?
This figure can also be called alternative cost, as it is the price of not choosing an alternative option.
How is opportunity cost relevant to business?
Opportunity cost calculates the potential losses or gains of an alternative option or choice. Businesses use this calculation to determine the most profitable and beneficial decision.
How does opportunity cost relate to economic profit?
Economic profit is a calculation used internally in business to determine strategy. It takes accounting profit and factors in opportunity cost as a theoretical expense. This new value allows the company to compare the actual profit against the potential theoretical profit.
What is the risk with opportunity cost?
Risk is the possibility that the projected outcome of a decision does not align with the actual outcome. Opportunity cost considers the possibility that the returns of a chosen option are not as high as the returns of the alternative. Risk deals with the projected and actual returns of one investment, and opportunity cost deals with the actual returns of multiple investments.