What is Opportunity Cost?
Opportunity costs refer to the potential benefits that companies or businesses relinquish when choosing one alternative over another. It is a concept that usually applies to economics and financial management. In other words, it represents the value of the next best option when a company chooses a project or investment. Opportunity costs aren’t real costs. However, they are still relevant to decision-making.
Opportunity costs only arise in the presence of multiple choices. If there is no choice provided, then the decision-making process would have a cost of zero. However, when there are two or more decisions to choose from, opportunity costs will arise. For example, when selecting Project A instead of Project B, the opportunity cost will be the benefits relinquished from Project B.
How does Opportunity Costs work?
When making decisions between various projects, companies always prioritize ones with the highest returns. However, due to certain limits, they may not have the option to choose both at the same time. Therefore, they usually choose one project over the other. While the selected project may increase profitability, the foregone project will become the opportunity cost.
Opportunity costs apply whenever any entity has to choose between two decisions. Whether the decision-maker is an individual or a company, they will incur an opportunity cost. These usually add to the explicit costs of the entity, which is also a concept in economics.
How to calculate Opportunity Costs?
For financial analysis, the opportunity cost of a decision is the value of the relinquished option. Usually, it comes in the form of the Net Present Value (NPV) of the decision. Therefore, the opportunity cost will have the same formula as the NPV of a project, which is as below.
NPV = CF0 + (CF1 / (1 + r)1) + (CF2 / (1 + r)2) + … + (CFn / (1 + r)n)
In the above formula, ‘CF’ represents the cash flows from the project. ‘r’ signifies the required rate of return or discount rate. Lastly, ‘n’ represents the total number of periods a project will run.
What are some examples of Opportunity Costs?
A company, Red Co., has a choice between two projects. However, due to capital restraints, the company can only choose one project. Project A, the first project, has an NPV of $10,000. On the other hand, Project B has an NPV of $12,000. For Red Co., the choice is simple, to choose Project B. Therefore, the $10,000 NPV that the company does not capitalize on Project A will become its opportunity costs.
Another company, Blue Co., has the option to sell one of its assets for $20,000. However, the company can keep using it, in which case it will bring $25,000. However, the returns from continuing its use will come in a few years. If the company chooses to sell its asset, it will relinquish the $25,000 in the future. On the other hand, if it keeps using it instead, it will lose the $20,000 sale proceeds. Either way, the company will suffer from opportunity costs.
Practically, however, opportunity costs are more complicated. Nonetheless, in essence, it will stay the same.
Opportunity costs come due to the availability of several options. When presented with several choices, opportunity costs will be the cost of the choice not taken. Usually, opportunity costs come in the form of the NPV of the foregone projects for companies.