Opportunity cost can be rightly defined as a decision that changes your way of handling your finances. There are lots of aspects of your life which can get affected owing to opportunity costs.
Your entire career, money as well as elements of lifestyle can get impacted by this. Life is all about making a decision, and here too, you have to make one. You need to choose one option over another. In order to understand the opportunity, cost better, you have to ask yourself questions.
You have to play out scenarios in your mind about what would happen if you chose one path over another.
Finance and money
Right from the time, one decides against going to one particular college over another; a person is making a conscious decision that would impact his entire life. In terms of money and other finances, opportunity costs can have a huge impact on your life.
For example, if you are not saving enough money for your post-retirement phase, then, in the end, you will find yourself having thousands of dollars less than your peers. If you have also let go of a blue chip instead of one that never took off, then also you suffer certain losses.
Explicit and implicit
Different economists over time have broken down opportunity costs into explicit and implicit ones. Different people involved in small businesses, often leverage opportunity costs in a positive manner. They make decisions that would have really positive consequences later in life.
A lot of research, as well as studying, is done before a person decides opportunity costs. Outcomes of your decisions to said new investments in your company will showcase whether your decision regarding the same was correct or not.
In implicit opportunity cost, the whole formula is a little different. This is because of the absence of any kind of direct accounting taking place. Suppose the owner of a business, decide not to take home any salary after setting up a new office.
This decision of his although apparently looks to harm his finances, but in the long term, it is perfectly beneficial for him as well as the company. This kind of business acumen is really important for making things work in the world of startup and businesses. The decision that is being taken here is good for long term health of the company.
No concrete mathematical formula exists for calculating what the opportunity costs are. There are some considerations that one has to make if he or she sits down to calculate opportunity costs. To put it simply opportunity cost is the amount or thing that you are sacrificing divided by what you are gaining from that activity.
If one looks a little closer, then all opportunity costs would look like options that are required to be weighed before selecting one. The main aim here is to make a decision that would add a little value to the finance or business. One has to ask himself what is being gained by taking a particular decision.
Factors influencing opportunity costs
There are three main factors on which calculation of opportunity costs depend. These factors are money, effort as well as time is given. When thinking in terms of money, you have to ask yourself what you would have done with that amount if you were not to spend it one decision.
People need to realize that once a certain amount has been spent, there is no chance of getting it back immediately. Options are therefore always required to be explored before taking a final decision.
Time and sweat
In businesses, one has to always consider time as a measurable commodity. While calculating opportunity costs, you may even find that time as an entity is even more worthy than cash. When you look to choose a particular opportunity, you have always to consider the amount of time you may need to invest behind it.
Work needs to be a priority for all those people who wish to start their own ventures instead of climbing up corporate ladders. Some amount of extra effort would always be required for a startup. You also need to be ready for giving in such efforts.
Terms associated with opportunity costs
There are negative as well as positive impacts associated with opportunity costs. During the calculation of opportunity costs, it is always quite tempting to think like an accountant. This means you would simply be weighing the amount of cash you are spending against the amount of cash that you would be gaining. However, there are certainly other factors to consider before you choose to think in that manner. The law of increased opportunity cost can take place even without you spending a single dime.
Tradeoffs and sunk costs
When a comparative advantage exists, it means that the company is able to produce their goods at a cost, lesser than its competitors. Sunk costs have essentially occurred in the past. They should not essentially be taken into much consideration during decision making since nothing can be done to change them.
Tradeoffs, largely trigger decisions associated with opportunity costs. When you have a certain amount of money in hand, it is up to you to spend it on giving a better look at your business or spend it on improving internal machinery of the same.
Risk and opportunity costs
Risks are not the same as opportunity costs. Risks are those potential downfall causing factors in your business, which arise from any financial or lifestyle decision that you take. Whereas opportunity cost will tell you what you could have done if you had made use of that resource by spending it in an alternate area.
The Benefits of Opportunity Cost on the Future of Business
The task of running a business is never an easy task. The company may not have to be one whose turnover is in millions. Even a business with limited investment often has to take the risk to stay in the market.
The hassles of running a successful business:
The directors of a firm or the person in charge of running the firm have to take a variety of decisions regularly like balancing of books, updating of inventory and most importantly draw up a strategy which will help the business to thrive in the current competitive market. During the process of deciding the marketing plan or policy, the officer often eliminates several suggested options and ends up choosing which is suitable for the firm. During the elimination process, the firm incurs a bit of risk even if the final result of taking that decision benefitted the company.
What is opportunity cost and how can it help in running a business?
This is where opportunity cost comes into play; opportunity cost is nothing but something which company gives up or trade-off as a consequence of their choice in the decision making. Walter Wessel in his book, “Economics” stated that the second best choice which we gave up for the first choice falls under the opportunity cost category.
We will try to make it easier for our readers by using a real-life example, suppose a company decides to spend money in their research and development department to improve the product quality instead of depositing the money in an interest-generating saving account. The decision of investing the money in R&D department may prove to be beneficial in the future, but the company is also burning a hole in their future investment by spending the money in remodelling.
Now, opportunity cost also includes non-cash assets as well such as labour force and valuable time. For example in the case of IT staffs, they may spend their time and labour in improving the customer database instead of spending that time in upgrading the company’s accounting records and entries; this can also get regarded as the opportunity cost.
The types of opportunity cost:
Now, the opportunity cost is broadly divided into two parts. We are all well aware of how accounting cost gets denominated in dollars, but opportunity cost can get separated in monetary value and non-monetary price. In some cases, this particular cost is intangible as well.
In the book “Essentials of Economics” written by N. Gregory Mankiw explained that the value which involves outflow of cash could be called explicit opportunity cost and the cost which does not include cash outflow is known as implicit cost.
To make things easier for our reader we will break down this definition by using an example. Suppose a coffee shop decides to buy an espresso machine for their shop may cost their labour quality training to make foaming espresso.
The particular opportunity cost may often get personal when a small-time businessman decides to reinvest his profit in his business thereby costing his family and him a quality vacation trip. The vacation may have helped the person in refreshing his mind and perform better in his job which gets sacrificed can get regarded as opportunity cost.
The benefits of opportunity cost:
Opportunity cost is not all bad firstly because they put the interest of the firm ahead of everything and secondly; it helps the decision maker to make a better decision for improving the outcome.
While making a decision when we emphasis on this particular cost it helps the director to make possibly the best decision for the firm.
For example, when a company finds that the initial decision is not fetching the satisfactory outcome, they may change the path of the company toward the other alternative opportunity cost. In the case of the IT department used in previous example, if the firm finds the decision to improve the customer database is not fetching the desirable result, they can revert their path towards upgrading the financial database of the company.
In some cases, the decision maker of the company fails to identify the opportunity cost until a decision gets implemented. The outcomes of the decided decision help the firm to identify the opportunity cost the firm incurred.
A few years back, people started following a new dieting method called the Atkins diet which allows a person to control their carbs intake. Now, a sandwich company could have never predicted such type of trend before and their decision to not go with steak shop cost them dearly.
The principles of opportunity cost:
As we have already said it is tough to predict the opportunity cost but using some basic principle while assessing the opportunity cost may prove beneficial for the company. The person in charge of determining the value must follow a basic opportunity cost principle which will make his job much more manageable.
The tenets of Opportunity cost are:
- The person who is responsible for assessing the price must have all the prerequisite knowledge about the economic condition of the market. The person should be good enough to make a decision which is economically viable for the company based on the factors such as benefits of taking the path and costs associated with the track.
- The person should broaden his mind while making the decision and look at other factors other than economics as well.
- The parameter or criteria used by the person to select an option should be preferred while assessing other options as well. His mind should be free from, and he should not practice the method of isolating the preferred choice by isolating it.
Nancie L Beckett has been a popular figure in academic circles for quite some time now. She hails from the University of California and teaches finance to her beloved students. She has an MBA degree and 6 years of experience in the same sector. The way of her teaching boring financial subjects really captivates the students.