Opportunity cost effects you, even when you aren't thinking about it! Why? Because opportunity cost is the loss of potential gain from other alternatives when one alternative is chosen. Meaning, every decision you make has an opportunity cost!
In this article, we will arm you with the basics of opportunity cost so you can make the most out of your decision making!
1: Opportunity Cost Definition
2: Opportunity Cost Equation
Now that you have the definition of opportunity cost, lets focus on the second thing you should know:
Opportunity Cost Equation
Opportunity Cost = Return from the best option not chosen - Return from the chosen option
This equation leads us to number 3 on our list, an example of how this equation works!
3: Opportunity Cost Example
Consider a company who is deciding whether or not to hire a new staff member to complete work, or to implement technology that can complete the same tasks. Opportunity cost would be the time and cost of both options vs the results yielded.
For example, hiring a new staff member requires training to get them up to speed before they can start completing the desired tasks. A few costs to consider when choosing this option are:
1. The new employee's wages
2. The wages required to train the new employee
3. The revenue from work not being completed during this ramp up period
Now that you have the cost, it needs to be benchmarked against the work they will complete once established. This number would then be used to compare the alternative; implementing technology.
Obviously, technology will come with a learning curve, time to train current staff on the systems, a monthly or yearly cost, and loss of revenue from work not being completed during the ramp up period. This same time and monetary contribution would need to be benchmarked against the work staff will be able to complete once established on the new systems.
Looking to both final numbers would determine which opportunity would cost more to pursue.
Here is how this equation would look:
Cost of new staff member and the revenue/time savings it yields - cost of implementing technology and the revenue/time savings it yields = opportunity cost
4: Opportunity Cost Vs. Sunk Cost
It is important to consider sunk cost when determining if an opportunity is viable. Sunk costs are defined as money that has already been spent and cannot be recovered. When thinking about sunk costs and how it effects your opportunity cost, consider the following questions:
What is the downside and potential the sunk cost brings vs having to acquire something new to yield the same opportunity cost result?
5: Opportunity Cost and Risk
Opportunities are great when they go as planned... but what if they don’t?
It is important to understand the risk associated with an opportunity and the potential financial downside.
For example, if a company needs to leverage (or borrow) $1M to take on a project that will yield a $2M return, the opportunity looks attractive! But what if the opportunity falls through after the funds are secured?
The business would be obligated to repay the funds and any early repayment fees, interest, and other potential negatives, such as credit report hits needed to secure the financing.
Alternatively, if the company decides to pass on the $2M project altogether, the downside would be limited to reputation and/or not being considered for future projects.
6. Opportunity Cost Comparison
Most small business owners and leaders make decisions based on what they feel will be best without considering every cost.
It is not possible to take on every opportunity that comes, so it is important to make decisions based on an opportunity cost comparison. When using opportunity cost and taking the time to calculate it, you learn quickly which decisions are best for the company.
If a business owner decides against this, they will be relying on luck to support their business. Eventually, luck will run out and the company might fail. Unfortunately, we see this regularly in businesses from year 3, 5, 7, and even companies who have been around for 20+ years.
7. How Decisions Influenced By Opportunity Cost Impact a Company
Decision making, either by feelings, luck or calculation have risks attached to it. To be successful in business you must become efficient in mitigating those risks. When you have your life's hard work on the line, and families you are supporting on your payroll, it makes sense to use the tools you have at hand. Opportunity cost is a great decision making tool that is worth the time it takes too calculate!
8. Statistics!
- The average adult makes 35,000 decisions each day!
- Businesses who calculate risk are 15% more profitable!
- Businesses who benchmark their performance grow 5 times faster than those who don’t!
You can see why taking the time to be strategic, and calculating your decision making can make a huge impact on your company!
9. How To Get Support
If you would like to understand opportunity cost better and apply it to your own business, we are here to support you! We would be happy to connect and see how we can partner with you on your journey through business. To learn more about Galaxy Consulting Group and how we support businesses like yours, check us out here.
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