Finance describes costs that are not measured by accountants but nonetheless important in business decisions. One such cost is the opportunity cost, or the cost of the “road not taken.” Opportunity costs are not recorded on the general ledger or documented in the financial statements.
Opportunity Cost Definition
Economists refer to opportunity cost as the “value of the next-highest valued alternative.” A simple example involves deciding whether to spend Saturday afternoon at the movies or at work, earning overtime. If you choose the movies, the opportunity cost is the amount of money you would have earned at work. If you choose work, the opportunity cost is the value of the pleasure of spending an afternoon watching movie.
Business Example of Opportunity Cost
Opportunity cost analysis is used in making decisions about product lines, equipment investments, or mergers and acquisitions. For example, when a small business is approached by a larger company and offered a buyout, the small business owner must decide what is more valuable: staying in business or accepting a buyout. The value of the option not chosen is the opportunity cost. For example, assume Sally of Sally’s Seashells earns $15,000 in profit every year for selling seashells by the seashore. Big Whale Enterprises offers Sally $200,000 for her business. Assuming Sally will stay in business for at least another 20 years, her future profits might total $300,000 over this time frame.
However, Sally has never seen $200,000 all at once before. Plus, anything could happen in 20 years. Her business might get blown away by a hurricane, or seashells may lose their popularity. Depending on how much Sally values having $200,000 right now opposed to $300,000 after 20 years, plus the uncertainty of staying in business, she might go ahead and accept the deal.
Calculating Opportunity Costs
Calculating opportunity costs is not always easy. In the first example above, it is easy to calculate the opportunity cost of going to the movies: it is simply the total amount earned at work, $200 for this example. But what if we decide to work instead? This opportunity cost is not as easily quantifiable. Doing so would mean assigning a dollar amount to the pleasure realized when spending an afternoon at the movies. We know one thing: it is less than $200, because, obviously, we chose work over the movies. We have another piece of the puzzle: We were willing to spend money on movie tickets, popcorn, and transportation totaling $50. We know the opportunity cost is somewhere between $50 and $200. To get even closer, we might ask, “If I earned $150 at work, would I still choose work? What about $125? $100? If $100 is your breaking point, then that is your opportunity cost of choosing work over the movies.
Similarly, in the business example above, Sally might ask herself, what would make her choose to stay in business rather than choose the buyout? In this way, she would quantify the value she assigns to seeing the money right now (time value of money) plus the uncertainty (risk) of the business lasting 20 years.
When reading financial statements, investors consider if there are any opportunity costs not shown in the income statement. That is, what investments, upgrades, or business opportunities did the company forgo that may have been ill-advised? If the company had taken advantage of these opportunities, could it have earned a profit or avoided a loss?
About Sara Huter
Sara Huter has over 15 years experience in the banking and energy industries, and over 10 years as an adjunct professor. Her work has been published for BusinessBee.com, the International Directory of Company Histories, the Encyclopedia of Business Insights: Global, EHow.com, and Examiner.com. Find out more about Sara at her Google+ Profile.