Opportunity cost is largely defined as a decision you make that alters your personal landscape going forward.
Opportunity costs can impact various - and critical - aspects of your life, including money, career, home and family, and other lifestyle elements. In general, it means having to choose one option over the other, be it money, time or lifestyle choices - and living with the consequences.
If you are a business owner, opportunity cost is going to come into play frequently. You will have to spend a lot of time weighing whether or not the inevitable consequences of a given decision are outweighed by the gains that decision will bring. And whether business or personal, opportunity cost will often be a tangible figure.
To gain a different perspective on opportunity cost, ask yourself this question: What scenarios can occur if I opt for one path over another? What's more, what outcome am I leaving on the table and how is that my opportunity cost?
Explicit vs. Implicit Opportunity Costs
Economists break down opportunity costs in two ways - via "explicit" and "implicit" opportunity costs.
Explicit opportunity costs
An explicit cost is, as one would imply, a cost that is explicitly shown in your accounting records. It's a cost that will be reflected somewhere in the income statement.
Let's say you own a landscaping company and you add several brand-new lawn mowers to your business for $3,000. In that regard, your explicit opportunity cost is any alternative use of that $3,000. The cash could have been used to place more advertising in your community, to upgrade your company's website, or as a down payment on a new truck for your company. What outcome results from your decision to buy those lawn mowers over other business options is the manifestation of your opportunity cost.
Implicit opportunity costs
With implicit opportunity costs, the formula is moderately different, primarily because there is no direct accounting cost stemming from implicit opportunity cost (i.e., you chose to spend $3,000 on lawn mowers over a down payment for a new truck for your company.) Consider a small business owner who foregoes a salary, even though the business owner's substantial business skills and acumen are integral to the success of her business. By electing not to take a salary, that business owner's unpaid salary is an implicit business cost. By foregoing a salary, the business owner is taking financial pressure off the company and boosting its chances for success at a critical stage (i.e., the launch of a business when money is tight and extra cash is critical). Here, the business owner is making an implicit cost decision for the long-range health of her company.
In both examples, the landscaping company owner and the small business entrepreneur are leveraging opportunity costs in positive ways - they're making choices fully cognizant that the decisions they're making do have real-world consequences.
Yet the research, study, and due diligence they bring to their decision-making processes increase the likelihood that they're making the right kind of opportunity cost decisions.
Opportunity Cost Examples
The examples of opportunity costs in business are fairly self-explanatory. Buying new machinery for your factory has a clear explicit cost. A small business owner declining an annual salary is a clear implicit cost. But what are some of the ways opportunity cost can pop up in and impact your individual life?
Opportunity costs start fairly early in life. What if you choose to go to college, or opt to learn a trade? Or, if you go to college, which major do you choose? And if you opt to learn a trade, what happens if you choose to be an electrician or if you decide to open a landscaping company?
Opportunity costs also impact your personal happiness. Ask anyone who's ever been divorced what their life would be if they didn't get married, or were married to someone else? Or, what if you decided to pass on buying your dream house because the timing wasn't right, and learned it increased significantly in value two years later?
In money and finance, opportunity cost can have a major impact on your life path. Not saving for retirement until age 35 instead of starting at age 25 could mean hundreds of thousands of dollars less when you finally call it a career (which is a substantial opportunity cost). Or, passing on an Amazon.com-like stock in favor of a stock that never takes off could also alter your financial path in life, and thus also represents an opportunity cost.
Another way to consider opportunity costs is to consider how history would have changed if John Lennon and Paul McCartney decided not to start a rock and roll band, or if William Gates decided to go work for IBM instead of starting his own software company.
Certainly, both music and business would have changed dramatically if those scenarios had come to pass.
How to Calculate Opportunity Cost
While there is no hard and fast mathematical formula for figuring out opportunity costs, that doesn't mean you can't weigh considerations that could sway cost decisions in one direction or another.
In general, the formula for figuring out your opportunity costs is as follows:
Opportunity cost = What you are sacrificing / what you are gaining
Let's take a closer look at that equation:
By and large, opportunity costs are all about options - and weighing those options before choosing one alternative or another. The goal here is making a decision that leads to value, i.e., what am I getting out of sacrificing one outcome, be it financial or lifestyle-oriented, and what am I gaining out of making an opportunity cost decision?
In that equation, the formula for figuring out opportunity costs gain clarity. Essentially, opportunity costs are what's left over after measuring what business, financial or lifestyle outcomes you gain against any sacrifices you're making. Basically, you're evaluating the "value" ratio between two or more options to accurately gauge opportunity costs.
Think of opportunity cost calculations in these real-life terms.
Imagine if you're considering a career move, from a public relations staffer to a public relations freelance specialist. While salary isn't the only factor in that decision (being your own boss, less need to commute to work, and having the chance to work for multiple clients, are also big factors), money is a big driver of opportunity-cost decisions.
As a corporate, full-time public relations staffer with 10 years of experience in the field, you were making what amounts to $35 per hour. As a newly minted freelance P.R. specialist, your income will likely be lower as you start out - let's say $17.50 per hour.
At first glance, it appears you're taking a big pay cut - and you are. $17.50 is, after all, half your hourly income as a corporate employee. But opportunity cost isn't so easily measured that way. The correct formula is to factor in sacrifice versus gain. In this instance, you're giving up $2 as a public relations freelancer for every $1 you're earning as a public relations freelancer in opportunity costs, right out of the gate.
Yet the chances are good that you'll grow your business. That's because you're a smart, motivated and experienced P.R. professional who may well earn $70 per-hour running your own business within a year or two. In other words, the gain is worth the sacrifice.
And that's an opportunity cost consideration you need to make.
Three Key Factors of Opportunity Cost
Ultimately, any worthwhile formula for measuring opportunity costs weighs on three key factors: money, time and effort, otherwise known as "sweat equity."
With financial considerations to weigh, the key question to ask before making an opportunity cost decision is what else would you do with the money you're about to spend on a single decision? The landscaper who chooses to spend $3,000 on mowers will have the mowers, but will never get that specific $3,000 back. That $3,000 that could have been spent on part-time help during the busy season, or on a new and improved website, is the opportunity cost of choosing to buy the lawn mowers.
Never forget that time is a commodity, too, just like ball bearings and Barbie dolls. In the opportunity cost realm, time can be even more priceless than cash. Consequently, when making any big lifestyle decision, always factor in the time needed (or saved) by choosing a specific opportunity.
3. Effort/Sweat equity
If you choose to start your own business instead of climbing the corporate ladder, for example, factoring in the extra effort needed to make a start-up business work should be a priority. That extra effort, which could lead to a successful start-up company, could constitute an opportunity cost that is missed if you decide to stay on the corporate track.
Terms Related to Opportunity Cost That You Need to Know
Opportunity costs are rarely cut and dried, and impacts that are both positive and negative come into play. Consider these key factors:
The law of increased opportunity cost
When considering opportunity costs, it's tempting to think like an accountant and weigh the cash you're spending (the sacrifice) against the cash you might be getting (the gain.)
But there are ancillary factors to consider, too. Take the law of increased opportunity cost, which can take place even if you don't spend a single dollar. Think of a coffee shop owner who takes a staffer off the register and asks him to work stock shelves, and away from customers. That could impact short-term sales, as the worker isn't directly waiting on customers and pouring coffee. But if the inventory isn't stocked, the business suffers, too, as customers have fewer options. If you send more workers away from the register to stock shelves, however, the front of the store counter-help thins out, and you'll likely lose more customers and more sales. That simple decision to send a coffee shop staffer away from the register is a good example of the law of increasing opportunity cost.
In terms of opportunity costs, comparative advantage means a company or an economy is producing more goods or services at a leaner opportunity cost than competitors. An example of comparative advantage lowering your opportunity cost could include outsourcing part of your production to a country that provides better economic value for that service.
By definition, sunk costs are costs that were incurred in the past, and are unable to be recovered. In real-world terms, buying an expensive watch that you lose at the beach is a sunk cost. A sunk cost is not always a bad thing for a business, and is sometimes simply inevitable; for example, replacing machinery in a factory means trying to scrap the old machinery. Anything that can't be scrapped is a sunk cost. Relative to opportunity costs, sunk costs shouldn't factor into ongoing opportunity cost decisions, as they cannot be adjusted or changed.
Trade-offs are the trigger for opportunity cost decisions. For example, if you have $100 and you have to decide whether to buy a new winter coat or take your SUV in for an inspection and oil change, choosing one over the other leads to a trade-off, as you can't have both. If you choose the coat, the trade-off is that you can't get your vehicle in for servicing, which is your potential opportunity cost.
A risk isn't the same as opportunity cost. While risk is defined as the potential for a downside result from a business, financial, or lifestyle decision, the opportunity cost is defined as the gain that could have materialized from an alternate usage of the same resource (i.e., using the $100 to service your vehicle instead of buying a winter coat.)