What is opportunity cost?

Opportunity Cost

We live in a reality where scarcity and choice are everyday realities. An individual can not both spend the day at home and at work, earning an income. A business or an investor faces the same dilemma: in choosing to invest funds in project A, the potential benefits of project B can no longer be enjoyed. When choosing one opportunity, you have to let go of another one. Opportunity cost is the cost of not selecting the next best opportunity for your time, money, or other scarce resource.

Many costs are calculated in terms of money. However, just because you don’t have to spend money to do something does not imply that the options you face are without costs. For example, you don’t have to spend money to go for a hike or watch a sunset, but there is an opportunity cost there too. You could have used that time to do something else you value – visiting a friend or reading a book, perhaps.

Examples of opportunity costs

If you choose to spend two years and up to $200,000 on studying for an MBA at one of the top business schools, you are facing an opportunity cost, whether you like it or not. You could have used that money to go on a world tour visiting just about every country on earth. You will also lose two years’ worth of income. If you make that choice, it’s because you believe that having an MBA will get you a higher paying job and eventually you will recover the $200,000 and much more.

Opportunity cost doesn’t only apply to things with a monetary value though. If you decide to get up half an hour earlier every morning so you can leave for work before the traffic gets too busy, you lose half an hour’s sleep. Or you might have spent that time around the breakfast table with your loved ones.

There’s even an opportunity cost involved with choosing to read this blog. You could, instead, have been talking to a friend, or working in the garden, or taking the dog for a walk. Or you could have been reading the newspaper or something else instead.

The different types of opportunity costs: Explicit costs vs implicit costs

Explicit costs

These refer to the direct costs involved with a particular choice, i.e. expenses or business operating costs. In this case, there is either a physical transfer of scarce resources or business operating costs involved. In other words, this term refers to the clearly identified cash value of an expense. For example, someone paying $200,000 for an MBA or a business choosing to use a machine for one project and not another one.

This means that when we talk about explicit costs there will always be a monetary value involved. For example, money will need to change hands. The explicit cost of a company deciding to use its scarce resources to produce product A instead of product B can easily be identified from its financial statements.

The same is true for individuals: buying car A for $100,000 instead of car B for $50,000 will decrease your bank balance by either $100,000 or $50,000.

Implicit costs

These costs are often also called notional, imputed or implied costs. These are the costs one often misses because they are not immediately obvious.

If a business chooses to use its machinery, equipment, and labour force to produce military equipment instead of motor cars, the loss of human life that could be involved in the first choice is not easy to measure in financial terms, yet it is very real.

If another firm chooses to produce electricity by using coal instead of more environmentally friendly options, the harmful side-effects involved with the first alternative is often ignored. This is because it does not involve an immediately obvious financial cost, even if it leads to polluting the environment.

Another example of implicit costs includes if a business owner works long hours without taking a salary or if he or she uses their private vehicle in the service of the business without drawing a car allowance. In the previous example, the business is the clear winner. It could also work the other way round. If a senior manager who earns $100 per hour and who has trouble delegating tasks spends an hour on personally buying office supplies instead of sending his secretary (who earns $25 an hour), the business in fact loses $75. Of course, the boss will argue that he did a better job. Thus, this type of implicit opportunity cost is often not only difficult to pinpoint, or also open to debate.

A third example is where a country’s government fails to properly maintain the electricity network. When the grid eventually fails and there are long hours without electricity, the direct cost might only be the cost of technicians working overtime to get it fixed. The implicit opportunity cost, however, includes the heavy losses of production suffered by factories throughout the nation.

How do you calculate opportunity cost?

Opportunity cost is sometimes easy to calculate and sometimes very complex. Typically speaking, it’s easier to calculate explicit than implicit opportunity cost. Often the fact that the future is inherently difficult to predict can play a very important role. Looking at a few more examples might illustrate it better.

Explicit vs implicit opportunity cost

As we have seen above, explicit opportunity cost refers to expenses with a defined monetary value. Let’s say you have to choose between two machines A and B. Both have the same expected lifespan and technically they are similar. The one from Europe costs $10,000 and the one made in China costs $6,000. Choosing the European one comes with an explicit opportunity cost of $10 000 – $6,000 = $4,000.

If a factory owner chooses to use the machinery, equipment, and staff to produce 10 000 units of product A at $60 each instead of using the very same resources to produce 10 000 units of product B at $100 each, there will be an opportunity cost of $400,000 involved, i.e. 10000 x ($100 – $60). This is the cost of the business losing $40 per unit on 10 000 units.

Another easy example is when you have to choose between two jobs, A and B. A pays an annual salary of $60,000 while B only pays $45,000. A is also near to your home, so you will spend an hour less in traffic every day and save $200 a month on fuel.

Where it’s not so easy to calculate is if B was actually closer to your home and A much further. There will come a point where the higher salary offered by A is cancelled out by the higher fuel bills and car maintenance costs involved with B. There’s also the not so insignificant opportunity cost of having less time to spend at home if you choose A.

When uncertainty increases

Things become more complex when you have to choose between two options of which the initial expenses are the same. However, the eventual benefits they might generate can not be calculated with a high degree of certainty.

Let us go back to the example of sacrificing two years at a job. For example, you earn $50,000 a year and spend $200,000 on getting an MBA qualification. Your hope is to earn more money over the next 40 years with the degree. The extrinsic part of this equation is the $200,000 you spend on the degree itself plus two years of income at $50,000 per year. The total extrinsic opportunity cost is thus $300,000.

The intrinsic part is, however, not so easy to calculate. You can start by taking the average salary an MBA graduate earns at the moment. Let’s say the average is $70,000 a year, and deduct your current salary of $50,000 a year from that. This means you will immediately benefit by $20,000 a year when you start working with an MBA qualification. Inflation and increases disregarded, over $40 years that would equate to $800,000.

Not choosing this option will, therefore, cost you $800,000 in intrinsic opportunity cost. Deduct from that the $300,000 extrinsic opportunity cost you spent on getting the degree, and your net opportunity cost will be $500,000.

You are, however, assuming that the demand for MBA graduates will remain constant. You also assume that there won’t be an oversupply and a subsequent drop in MBA graduate salaries.

When uncertainty is very high

When it comes to opportunity costs in the investment world, things can become even more opaque. Let’s say you have to choose between investing in the shares of two different companies, both of which sell for $50 each at the moment.

Your decision should be based on which stock you expect will provide the highest return in terms of price increases and dividend payments over a given time period. This type of information is only available with hindsight, the benefit of which you don’t have when making the decision.

There are of fortunately quite a few statistical models on the market to help you make such a choice. All of them are, however, based on past performance. The stock with the best performance over the last 10 years might not necessarily be the one that performs best over the next decade. Apart from that, an economic recession or a natural disaster can wreak havoc with even the most advanced calculations.

What are sunk costs and why are they excluded from the calculation?

Sunk costs are expenses that have been incurred already, in that there is no way to recover them. They are sometimes also called historical costs. Since these costs refer to costs incurred in the past, it’s a reality that can not be changed. Sunk costs can refer to indirect costs or direct costs. If one is able to summarize sunk cost as a single component, that means you are dealing with a direct cost. If sunk costs impact several departments or products, it is an indirect cost.

When studying the breakdown of costs, sunk costs can also either be variable costs or fixed costs. Although sunk costs are more likely to be fixed. When a business, for example, decides to stop making a specific product or component, the sunk cost typically includes variable costs such as materials and electricity but also fixed costs such as rent and interest on loans.

As a general rule, the more versatile, liquid and compatible an asset, the less the chances are that it will become part of sunk costs if things don’t work out. Let’s look at an example. A firm spent $10,000 on advertising and marketing to boost the exposure of a new product to potential customers. Eventually, however, the campaign was not a success. The $10,000 now becomes a sunk cost. The company should not take it into account when making decisions on how to proceed from there.

Many people, however, often make the mistake to try and recover sunk costs. In the process, they might spend even more time and money that eventually also become sunk costs. When it comes to sunk costs, the lesson is simple: Cut your losses and walk away.

Externalizing costs

Some costs do not directly affect those responsible for them. However, they might affect certain groups of society – or society as a whole. The tobacco industry, for example, might make huge profits while passing on the costs to the healthcare industry as well as the economy as a whole. Companies that pollute rivers, the sea, or the atmosphere might not suffer any opportunity costs. These costs are nevertheless there. They are just being externalized to the rest of society in the form of polluted drinking water, a decline in marine life and global warming.

When is it relevant to calculate opportunity costs?

Calculating opportunity costs can be useful in virtually all business decisions. It allows the owners and top management, who are nearly perpetually faced with different options, to determine what the most profitable and valuable choices may be. Doing this can in the long run have a significant positive impact on the profitability of the business.

Wrap up

This article has reviewed the importance of opportunity costs and how to estimate them in a variety of situations based on their implicit and explicit costs. If we consider all the costs we could have incurred by taking a different course of action, we can better assess the choices we can make.