What is Opportunity Cost?

Opportunity cost is the measure of potential loss in decision making. Life is full of choices, and with every choice there is an inherent loss of opportunity that comes with the road not taken. For instance, when choosing to have children there is a certain loss of freedom, loss of disposable income, and women may suffer from potential job growth due to time away from her position. Of course, most who go on to have a family feel that the benefit outweighs the cost. This type of thinking can be applied to all aspects of life, but is especially useful when considering business economics. In business, opportunity cost is the value of the next highest alternative use of a resource.  These typically fall into two categories: explicit costs and implicit costs.

What is an explicit cost?

An explicit cost is an actual expense that a business incurs as a result of their decision-making process. For example, a company may have $100 to spend on a new printer. The $100 spent on the printer is the explicit cost of the decision. It represents $100 that could have been spent in other aspects of the business. A business may be in need of a new printer, but spending $100 on additional advertising may be more beneficial.

What is an implicit cost?

An implicit cost is not reflected by cashflow. Instead, it is the result of how a business allocates its assets. A business may have to choose between different options for using their assets. The value of the most beneficial not taken option is the implicit cost. An example of this may be when a city government has to decide what to do with a parcel of land. If they are choosing between building a community center, a post office, or selling the land, they would need to consider the benefit to the community, the potential revenue that would be produced, project long term real estate value, as well as the benefit to the community.

While calculating opportunity cost, it is important to consider not just the cost of your option, but also the cost of not taking another option. An example of this would be pursuing a college education. Say a student’s annual tuition is $10,000. The opportunity cost of pursuing the education is not just 10K, you would also have to include the cost that the student is missing out on. If the student could potentially make $25,000 annually, then the true opportunity cost is $35,000 annually after including the foregone earnings. While evaluating for opportunity cost, do not include expenses that you would have under any normal circumstance. A brick and mortar business that is trying to decide if they are going to take their business online will have to consider the additional expense, as well as the potential gains of going online. If they plan to continue to have a brick and mortar location, regardless of their online status, then their rent should not be a factor in calculating their opportunity cost.

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