Opportunity cost definition
Opportunity cost (also known as “alternative cost,”) is the difference between a project’s cost estimate and another option that must be foregone in order to implement the project.
Every choice we make also means giving up another option. If I buy a building, I won’t have the time and money to buy a different one, or to invest in technology.
When a business is faced with different choices, it must assess the costs of each option if it wants to make a strategic choice. Opportunity cost is the difference in the cost of two options.
“Taking the time to assess the opportunity cost is important to make a choice based on numbers rather than just instinct or enthusiasm,” says Simon Brassard, Manager, Major Accounts, BDC.
How to calculate the opportunity cost?
Opportunity cost formula
Cost of one option - Cost of the other option = Opportunity cost
Example of opportunity cost calculation
Let’s take the example of a company that manufactures metal pipes.
“Currently, a plant employee generates $100 in profit after a day’s work,” says Brassard. “To launch a new project that will improve the manufacturing process, the company needs to take two of its employees and train them. That will mean they will each generate only $75 a day for three months, or 12 weeks of work. However, after three months, the company estimates that they will generate $150 a day in profit for the company.”
In this situation, you would calculate the opportunity cost as follows:
Have two employees work for 60 working days:
60 days X $100 = $6,000
Train both employees:
60 days X $75 = $4500
Opportunity cost: $6,000 - $4500 = $1,500
The opportunity cost is $1,500 to carry out the manufacturing process improvement project compared to maintaining the status quo.
How does opportunity cost affect decision-making?
To make an informed decision, the company must then assess how long it will take to absorb the opportunity cost and begin to make a profit from its choice.
Let’s continue with the example of metal pipe manufacturing. The company estimates that both employees will generate an extra $50 a day in profit once their training is completed.
The following calculation will tell you in how many days the company will start turning a profit:
$1,500 opportunity cost / $50 extra profit per day = 30 days
So after only 30 days, the company will have recovered its investment and will then make an additional $50 a day in profit with each of these two employees compared to the period preceding the training.
“Of course, all these calculations are based on estimates,” says Brassard. “Things can always change along the way and skew estimates. The company may have to abandon a project halfway through. You always have to keep that in mind, and the opportunity cost calculation helps make an informed decision. But generally speaking, the company knows its business and its market well, so its estimates should be fairly accurate.”
The example of pipes is very concrete, but sometimes the opportunity cost is more difficult to quantify. For example, if you’re considering acquiring a business.
“If you ask your financial controller to assess an acquisition, they will spend a lot of time and effort, and during that time they will not focus on their regular duties,” says Brassard. “Like controlling costs. Will it end up costing the company a lot of money? This is a something to consider.”
He noted that entrepreneurs with limited resources may want to evaluate whether outsourcing this work could be worthwhile. “But again, there are costs involved,” he says. “Is this project important enough for the company’s growth to outsource the analysis work? This is a more complex opportunity cost to estimate.”
While the opportunity cost may not always be accurately assessed, it is worthwhile for any company to determine it before making a business decision.
Opportunity cost and inventory management
The opportunity cost of inventory management can also be assessed. That’s because there are many costs associated with excess inventory, including storage, that are often hidden.
Take, for example, a company that sells goods that cost $8 million a year. This company could hold $2 million of inventory at any given time, which means it turns over its inventory four times a year.
By reducing inventory levels by 20% and adding one cycle of inventory turnover per year, the company can free up $400,000 of working capital. That money can then be invested elsewhere, for example in additional production capacity, which translates into significant opportunity cost gains.
On the other hand, having less inventory could mean that the company would have to turn down two large orders of $100,000 a year, that have a gross margin of 35%. These two orders, worth a total of $200,000, would therefore cost the company $70,000 in net income, and ultimately, in working capital.
Cost of one option: maintain inventory at the same level
Cost of the other option: reduce inventory by $400,000 and subtract the net income lost due to turning down two orders
$400,000 - $70,000 = $330,000
Opportunity cost = $400,000 - $330,000 = $70,000
The cost of carrying out the project is therefore $70,000 compared to maintaining the status quo in terms of inventory.
In order for the reduction in the company’s inventory to be profitable, it would have to ensure that the projects carried out with the $400,000 in cash saved on the inventory could generate net profits of at least $70,000.