How to use opportunity cost to make financially sound decisions
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Successful businesses frequently look ahead. Financial forecasting helps prepare for future decision-making. But there is one metric that often gets ignored in forecasting: opportunity cost.
Calculating opportunity cost helps businesses assess potential strategies and determine the economic potential of each. Because the calculation is comparative in nature, it’s an ideal tool for evaluating multiple choices.
Opportunity cost uncovers the “hidden cost” of each choice, giving you a clearer picture of the potential gains and losses.
In this article, we'll walk through how to calculate opportunity cost and provide examples of when to use it to make financially savvy business decisions.
What is opportunity cost in business?
Opportunity cost is the hidden cost of choosing one option over another. It’s often discussed in the context of personal decisions: if you have $15 and spend it on a movie, you can’t use the same $15 to buy a burger. The opportunity cost of watching the movie is eating the burger.
For businesses, calculating opportunity cost is usually more complex.
Imagine, for example, that you have $10,000 to invest and can only choose one project. Project A promises a 15% return on your investment. That seems pretty good until you look at Project B, which promises a 20% return.
In this scenario, the opportunity cost of investing in Project A is the +5% gains you miss out on by not investing in Project B.
Most businesses understand the necessity of tracking business expenses. But funding is a finite resource. Including opportunity cost in your calculations gives you additional insight to make smart decisions with the resources available.
What is the opportunity cost formula?
The simplified formula for opportunity cost is as follows:
Opportunity Cost = FO - CO
FO: Return on next best option
CO: Return on option chosen
Note that FO is the return on just the next best option, not every other option. When calculating opportunity costs, you are only comparing the top two viable choices.
If the opportunity cost is positive, this means your return on the next best option is higher than the option you are choosing. This is a good indication to reconsider your decision, as it will cost your business that amount to go forward with the current option.
If the opportunity cost is negative, this means the return on your chosen option is higher than the next best option. This is a good indicator that the option chosen is the most financially viable option.
While this formula is fairly straightforward, you’ll need to dig deeper to calculate the return on each option.
How to calculate return on investment for each option
To calculate return, you’ll need to know the final expected value and subtract the initial cost of the investment. As a formula, it looks like this:
Return = Final expected value - Initial cost of investment
Final expected value
The final expected value is the final amount of money generated from the investment. So if you invest $10,000 and expect a return of 20%, the final value will be $10,000 + [$10,000 x 0.20] = $12,000.
Initial cost of investment
The initial cost of investment is the total amount of money you spend “out of pocket”. If you need to put in $10,000 to set up your investment, that is your initial cost.
Where this calculation gets tricky is that you might not be spending the $10,000 all at once. For example, if the $10,000 is going into a marketing budget, you might spend $3,000 for an advertisement, then $2,000 for data tracking and $5,000 for personnel over the course of the ad.
Calculations get messy IRL, so you need a tracking system
Just like you might not invest your money all at once, you’re also not receiving your return in one lump sum. Maybe you get $3,000 of return each week for four weeks for a final return of $12,000. More likely, the returns will trickle in at different values every week.
Because of this, you need a tracking system that will allow you to accurately account for both your initial investment and your return. At the very least, you’ll want a system that allows you to track and forecast expenses and manage cash flow.
Examples of how businesses calculate opportunity cost
In the real world, calculating opportunity costs involves more than a simple formula. The ability to accurately track and forecast expenses and returns will make or break your opportunity cost predications.
Another element that must be considered is risk. All investments involve risk and understanding the likelihood of reaching the predicted total return is essential to making sound business decisions.
Finally, understanding the timeline of your return is also vital for evaluating opportunity costs. Some businesses (especially those just starting out) may value a smaller return in a shorter amount of time. Other businesses are stable enough to wait for a large return on a much longer time horizon.
Let’s expand on these concepts with examples.
Stock market example
Let’s say a business has $100,000 to invest in the stock market. There are many opportunities to invest, including stocks, index funds and REITs. The first step the business must take is to evaluate the desired risk and time horizon for the investment.
The stakeholders decide that they want a low-risk investment with a time horizon of 10 years. By evaluating the desired risk and time horizon, the business is able to narrow down the options to two options.
Option A: Invest in an index fund that has a projected return of 10% per year and an expense ratio of 0.75%.
Option B: Invest in an index fund that has a project return of 9% per year and an expense ratio of 0.2%.
The opportunity cost of choosing Option B is $142,222 - $132,428 = $9,794. In other words, the business would lose out almost $10k in gains if they chose option B. For this reason, Option A is the most financially savvy option.
Real estate example
Let’s say a business has $100,000 to invest in real estate. The first step the business must take is to evaluate the desired risk and time horizon for the investment.
The stakeholders decide on a medium-risk and a time horizon of three years.
Option A: A multi-family home with two units that are immediately ready to rent. Unit 1 will rent for $2,000/month and Unit 2 will rent for $1,800/month. The total revenue is $3,800/month.
Option B: A multi-family home with three units that need additional renovations. Each unit will need at least one year’s worth of renovations before renting, these renovations fit within the $100,000 budget. After the renovations, Unit 1 will rent for $2,300/month; Unit 2 will rent for $1,700/month; and Unit 3 will rent for $2,000/month. The total revenue is $6,000/month.
To calculate the opportunity cost, the costs and profit for each year must be calculated.
In this example, the opportunity cost of choosing Option A is $7,200. In other words, the company misses out on $7,200 by not choosing Option B. With this calculation, it’s clear that Option B is a better choice.
But if the time horizon was two years instead of three years, choosing Option B would have a higher opportunity cost. This shows how the time horizon impacts opportunity cost calculations.
Comparing more than two options
Oftentimes, you’ll be faced with more than two options but the opportunity cost formula only accommodates two. In this case, it’s best to calculate the expected return for each option along a given timeframe.
After calculating the return, it should be clear which is the “next best option” and the opportunity cost formula can then be applied.
Opportunity cost vs comparative advantage vs competitive advantage
As with many financial terms, opportunity cost often gets confused for other concepts. The two most often confused terms are “comparative advantage” and “competitive advantage.”
Comparative advantage is a term used to describe whole countries or economies. Specifically, it refers to a country’s ability to produce a good at a lower opportunity cost than other countries. Sometimes this term is used to describe an individual company that produces a good or service at a lower opportunity cost than its competitors. Comparative advantage does not take quality into account. It only measures the ability to spend less that competitors.
Competitive advantage, on the other hand, is used to describe the optimal point between making a good or service at a lower opportunity cost while also making it more desirable to customers. Competitive advantage considers comparative advantage, but also adds in the concept of quality.
How Ramp can help companies calculate opportunity costs & maximize value
Ramp is a cash flow management and expense management tool for small businesses that can track and project cash flow and expenses in opportunity cost modeling.
Once you’ve committed to a business decision, Ramp helps you maximize your return by letting you automate your plan.
You can add spend controls to different categories of expenses to make sure you’re not going over-budget. You’ll also have access to AI-powered suggestions for saving money so that each dollar invested goes even further.
Ready to forecast your finances? Get started with Ramp.
The formula is: Opportunity Cost = FO - CO. Where FO is the final expected value and CO is the initial cost of the investment.