Five Opportunity Cost Examples that Will Enhance Your Financial Decision-Making

What Is an Opportunity Cost? Why Does It Matter?

Opportunity cost is whatever you miss out on when you choose one thing over another. In more formal economic terms, it’s the value of the next best alternative that you forgo when making a decision. 

This concept is important for business leaders as it offers a nuanced lens for evaluating decisions. It goes beyond monetary considerations to include the potential benefits and losses of other possible options, so that you can account for long-term consequences.

There are two main components of opportunity cost — explicit and implicit costs. Explicit costs are tangible expenses that directly impact the bottom line, such as salaries and raw materials. Implicit costs are more subtle. They refer to the costs of using your own resources rather than selling or leasing them. Weighing both of these expenses is especially helpful when making financial decisions related to spending and investing.

Opportunity cost also plays a role in capital structure, which is figuring out how a company uses a combination of debt and equity to fund its operations. Each choice comes with pros and cons, so you have to determine whether debt or equity is the better choice for your needs. Although debt may provide immediate funds, it requires principal and interest payments. On the other hand, equity may not have explicit costs, but it means giving up ownership and potential future profits. Ultimately, the decision rests on whether the chosen capital structure aligns with your overall goals.

Five Examples of Opportunity Cost

1. Allocating Funds for Marketing Campaigns vs. Investing in Employee Development

Company leaders choose how to allocate funds, including whether to invest in marketing campaigns or employee training. Marketing campaigns can yield immediate results such as increased brand visibility and sales, yet prioritizing them might mean overlooking the long-term benefits of a skilled and motivated workforce.

For example, a growing company with a limited budget can decide between investing in a targeted marketing campaign to launch a new product line or allocating the same amount for employee training programs. The marketing campaign promises immediate customer acquisition and revenue boost, potentially increasing market share by 10% within six months. 

On the other hand, investing in employee training aims to enhance technical skills and foster a culture of innovation, leading to long-term productivity gains and cost savings. The challenge is balancing short-term gains from marketing with the strategic advantage of a highly skilled and motivated workforce for sustainable growth.

2. Investing in the Stock Market vs. Expanding Operations

CEOs must often choose between investing in stocks for quick profits or expanding operations to capture new markets. Stocks can provide immediate returns, but focusing on them could mean missing out on long-term growth. To decide, you can weigh the risks and rewards of each option and match them with your company's goals.

For example, a company with a $1 million surplus could invest in R&D, anticipating a 15% return within the first year. They could also invest it in the stock market, expecting a 20% return over the same period. Although investing in stocks could bring immediate gains for this company, focusing solely on this might mean missing out on the long-term benefits of product innovation.

3. Pursuing Entrepreneurship vs. Continuing to Work a Steady Income Job

Deciding to start your own business instead of working a stable job means giving up a guaranteed paycheck and benefits for the chance to earn a lot more money and feel more fulfilled.

If you stick with a regular job, you'll miss out on the freedom and chances to grow that come with running your own business. It's a choice between having financial stability and the possibility of achieving financial independence and happiness by being your own boss. 

In the end, it depends on how much risk you're willing to take and what's most important to you in your work and personal life.

4. Upgrading Equipment vs. Research and Development

At some point, you may need to decide between upgrading existing equipment or allocating resources to research and development. One offers increased efficiency while the other boosts innovation. Upgrading equipment offers immediate improvements but may come at the sacrifice of potential breakthroughs from R&D investments.

5. Offering Flexible Work Hours vs. Traditional Nine-to-Five

Another decision that benefits from an opportunity cost analysis is whether to provide flexible work hours for staff to enhance work-life wellness. The opportunity cost involves the potential sacrifice of a traditional work structure, which can cause concerns with team collaboration. Striking the right balance involves assessing the impact on employee wellbeing against potential challenges in maintaining a cohesive work environment.

How to Calculate Opportunity Cost

The opportunity cost formula is expressed as the difference in return between the chosen option and the next best alternative, divided by the resources invested. Another way to express this is: 

Opportunity Cost = (Return of Chosen Option - Return of Next Best Alternative) ÷ Resources Invested

Although it may seem overwhelming at first, calculating the opportunity cost of a decision is relatively easy. You can use this step-by-step guide to help determine which choice is the best option for your organization. 

1. Identify the decision. The first step is to clearly define the decision at hand and what alternatives are available. For example, deciding between investment opportunities. 
2. Determine returns. Once the problem is clear, you can identify the returns associated with the chosen option and the next best alternative. This could be something like financial gains or time saved. 
3. Assess resources invested. Next, you can consider the resources invested in both options. These resources can be tangible or intangible assets.
4. Apply the formula. Based on the previous steps, plug the values into the opportunity cost formula. 
5. Interpret the result. A positive opportunity cost indicates that the chosen option provides a higher return. However, a negative opportunity cost suggests that the next best alternative would be a better choice.

Here is an example of what this looks like for the opportunity cost of choosing Job A over Job B. In this scenario, Job A has a salary of $60,000 per year, and Job B has a salary of $55,000 a year. The resources invested are four years of time and effort to acquire the necessary skills. You can plug these values into the formula like this: 

Opportunity Cost = ($60,000 - $55,000) ÷ 4 years

The opportunity cost of choosing Job A over Job B is approximately $1,250 per year. This means that, for every year spent in Job A, the individual sacrifices an additional $1,250 in potential earnings offered by Job B. If the non-monetary benefits outweigh the $1,250 per year, Job A may still be the best choice.

Opportunity Cost vs. Sunk Cost

Sunk cost refers to money that has already been spent and cannot be recovered, regardless of future decisions. These expenses should not influence current decision-making processes, as they are essentially irretrievable. For example, if a company invests in a project that doesn't work out, the money spent on that project is a sunk cost. 

The key difference between these expenditures is when they matter in decision-making. Opportunity cost is about looking at the benefits of choosing one thing over another. Sunk cost is about old expenses that don't matter for current decisions because they can't be recovered. Knowing this distinction can help you make decisions based on what's ahead, not just on what's been spent before.

Opportunity Cost and Profit

Another thing to consider is accounting and economic profit. The difference between these concepts lies in their consideration of implicit costs, particularly opportunity costs. 

Accounting profit focuses solely on explicit costs — such as wages and rent — and is calculated by subtracting these expenses from total revenue. In contrast, economic profit incorporates both explicit and implicit costs to show all of the sacrifices made. 

For example, if a business owner invests $50,000 in their venture, and earns $70,000 in revenue, but could have earned $60,000 in a different opportunity, the accounting profit would be $20,000. However, the economic profit would only be $10,000. 

Aligning Opportunity Cost with Employee Wellbeing

Understanding opportunity cost is an important part of making financial decisions, but it also plays a role in enhancing employee wellbeing. For example, wellness programs can help optimize costs for better outcomes for both employers and employees. 

Wellhub wellbeing initiatives can help you tackle the opportunity cost of not having a healthy and engaged workforce. When wellbeing is a top priority, your employees can be more focused and committed while in the office. Investing in such programs can also lead to cost savings, as 85% of HR leaders report that wellness initiatives reduce talent management expenses. 

Talk with a Wellbeing Specialist today to explore ways to control costs through employee wellbeing programs.