You will not find it in financial statements nor in accounting ledgers. Yet, it’s a central idea in sound business decision-making, which should not be taken lightly. The opportunity cost is a virtual construct that could and should be applied in management as well as in finance, if not in daily life as well.
What is an opportunity cost?
In simple terms, when facing two choices, the opportunity cost is the missed potential gain from the choice that is NOT taken. It is an economical concept which can be applied for any decision making process at any organizational level: individual, department, company, or even an entire country.
Although frequently used for assessing financial outcomes, the said “cost” can represent potential gains which go far beyond the immediate financial terms. This may include aspects such as experience, quality, reputation, business prospect, and so on. Those aspects represent missed opportunities, hence the term ‘opportunity cost’.
While it could be used as a risk assessment tool in itself, it is highly encouraged to embed the concept of opportunity cost in one’s everyday thinking.
As an example, assume a company has a relatively successful high selling product for the past 3 years. Recently, a design flaw has been identified, and customer complaints started to build up with some number of warranty claims. In light of this situation, the managing team decides to meet, and two options have been identified:
1. Do nothing, revenues and gross profit are sufficiently high to offset any direct loss in warranty adjustments.
2. Accelerate the design and release of a new substitute product, with some disruption on sales volume.
This is a big decision, and several parameters are in play, including the economic environment of the company itself. In whichever choice, the loss of gains from the OTHER choice is what is considered the opportunity cost.
In this case, if the company opts for doing nothing, the opportunity costs could be the reputation damage, total cost of quality, and gradual decline in sales (on top of the currently minimal cost of warranty). Whilst if the company decides to accelerate the design of a new product, the opportunity cost would be a quick dip in sales (on top of the development and product release costs).
It is therefore most advisable to look at opportunity costs over a relevant stretch of time, to think of it as deciding between investments.
A high-school graduate who decides to skip university may save the tuition fees, on top of his income from work. However, on the longer term, his opportunity cost is the loss of potentially higher salaries from more advanced positions, which require a university degree.
Opportunity cost in finance
In the world of finance, where numbers dominate, there are two ways to look at opportunity cost:
1. During the evaluation of different investments, the opportunity cost constitutes the difference between the most profitable option and the one chosen.
As an example, if a company has the choice between investing in bonds vs. hiring more personnel to increase productivity, the difference in rates of return between those two choices constitutes the opportunity cost. While it seems easy to forecast, the actual differences, as most investors know, can only be correctly established in hindsight.
2. From a similar but larger point of view, when calculating the future returns of an investment, the applicable benchmark discount rate –in effect a form of interest rate- is considered the opportunity cost of capital. In other words, this discount rate represents the potential returns an investor could have gained elsewhere (e.g. saving deposits or other projects).
It is imperative that the investment’s rate of return be higher than this discount rate, otherwise, it is more beneficial to invest elsewhere, since the opportunity cost of capital would exceed the returns.
It is a virtual concept, yet its business implications can have an enormous impact, which sadly several executives overlook until it’s too late, resulting in enormous losses, and sometimes bankruptcies.
There are several reasons why we have a tendency to ignore opportunity costs: time pressure to execute a project, search for immediate results, unwillingness to study alternative options, overconfidence from past successes, and so on; all of which may, in a way or another, become a recipe for disaster.
For better decision-making, managers are advised to thoroughly assess the complete costs vs. benefits of their different options, over different durations. They should as well encourage the diversity of opinions, and maintain a healthy level of doubt and critical thinking.
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