Opportunity cost represents the benefits the business misses out on when picking between alternatives. When we have two desirable options, the benefit from the one not chosen is our opportunity cost.
These costs are usually the result of bottlenecks in business processes. Therefore, finance professionals use Opportunity Cost analysis to improve the decision-making process and make informed choices.
As an example, we can look at salary. If we take unpaid leave to go on vacation, our remuneration will be our opportunity cost. And if we work overtime this Sunday, the opportunity cost will be our leisure time.
Opportunity Cost Concept
The metric is a crucial concept in economics, representing the value of the next best option. In management accounting and finance, choices lead to opportunity costs. It’s a standard measure within the premises of various decision-making techniques.
Opportunity costs are unseen by definition, and we can easily overlook them. It is important to accurately identify those, as they can be essential to a better decision-making process. Also, considering opportunity costs usually results in businesses choosing the most profitable options.
Opportunity cost analysis is crucial when we determine the capital structure of the business. Both debt and equity require compensation for lenders and shareholders to cover the risk of investment. These funding sources also have opportunity costs. We use funds to pay back loans or distribute dividends instead of investing the amounts elsewhere, where they can generate returns.
When we have only one option, we always have the alternative of doing nothing. The opportunity cost of doing nothing is zero.
The metric is a forward-looking concept, a possible cost incurred by picking one option over the next best alternative. Analysts don’t know the actual rate of return on the compared alternatives.
Opportunity costs are not always referring to a monetary amount. Sometimes it’s not possible to quantify them at the time when we make the decision. We can only forecast and estimate, but ultimately we may face some opportunity cost that will only reveal itself in the future.
The concept is not applicable all the time. In some cases, it is not possible to perform a quantitative comparison of two alternatives. It works best when we have a common unit of measurement.
Risk represents the possibility that an investment’s forecasted and actual return rates are different, realizing a loss. Opportunity costs represent the chance that the chosen option turns out with a lower rate of return than the foregone alternative.
An important distinction is that risk looks at the same investment over time, while opportunity costs look at two investments in the same moment in time.
It is important to compare options with similar risks. There’s no point in comparing government bonds to shares in a fintech startup.
Explicit Opportunity Costs
Explicit opportunity costs involve direct monetary payments. If we pay € 500 for heating, the benefit foregone is the option to purchase something else with these € 500.
Implicit Opportunity Costs
Implicit opportunity cost is related more to resources, rather than money. They are also called implied or notional. They do not represent a direct cost, but the lost opportunity to use resources for something else.
Opportunity Cost Analysis
Opportunity costs are relevant in decision making, and companies often use them to evaluate and compare capital projects.
When analysts evaluate possible investments and projects, it is vital to analyze the related opportunity costs. When looking at capital projects, we should assess the expected return on the project, considering the opportunity cost, which is the expected return of the best alternative. We usually deem projects with an expected rate of return above the opportunity cost as viable investments.
As an example, consider an investment, which will use available office space that we are currently renting out. The evaluation of this project should consider the rental income that we will forego to use the area. This will be the opportunity cost of the new project.
Whenever we have two mutually excluding options, we would typically go with the one with the higher Net Present Value (NPV). If we analyze the alternative and find it has a substantial benefit at the beginning of its life, we may subtract it from the NPV of the chosen option, as it is our opportunity cost. Our decision-making process will change, and we will be looking for the option with a positive NPV, instead.
We use financial modeling to determine the opportunity cost of different endeavors. Analysts build Discounted Cash Flow (DCF) models to compare various capital projects and assess which one is better.
It is easy to make mistakes and include expenditures incorrectly in our opportunity cost analysis. The opportunity cost of going on vacation doesn’t cover expenses for food, as this expenditure will still happen even if we stay at home.
Accounting and Economic profit
It is essential to understand that the opportunity cost is not an accounting concept. It is instead a financial analysis concept. Therefore we do not present opportunity costs in the financial statements of the company. There is a difference between the accounting profit and economic profit of a project.
We have a land plot that we can sell for € 20 mil. The alternative option is to extract metals from it, an endeavor with a present value of € 60 mil, given we invest € 30 mil. The accounting profit from the second option is € 30 mil. However, from a business perspective, we need to consider the lost benefit of selling the land plot, bringing economic profit down to € 10 mil.
Implementing Opportunity Cost in Financial Modeling
To understand opportunity cost analysis, let us take a look at an NPV calculation. We are looking at a project which requires an initial investment of € 50 thousand. The amount will buy the business a machine that will bring an annual benefit of € 10,500 in cost savings over the next ten years.
The CEO has asked of us to review the project and evaluate its overall benefit, given the Weighted Average Cost of Capital (WACC) of the company is 10.50%.
If we go ahead and calculate the Net Present Value (NPV) and the Internal Rate of Return (IRR) on the project, we can see that the project will be profitable. It has a positive NPV, and the IRR is above the hurdle rate of 10.50%.
To make a better decision, we can look to add opportunity cost analysis to our evaluation. We have another machine in the company, that is not currently in use. If we go ahead with the project, it will be required to support the new installation. Otherwise, we can sell it for € 15 thousand.
The price at which we could sell the second machine is the foregone benefit if we go ahead with the capital project. We need to adjust our initial cash outflow with the opportunity cost.
As a result, we get a negative Net Present Value (NPV) and an Internal Rate of Return (IRR) of 9.82%, which falls below the cost of capital for the company.
Initially, the project appeared viable from an accounting perspective. However, once we consider the lost benefit of not selling the available machine, the project starts to lose its appeal. Here we should consider other factors, but if we only look at what NPV and IRR show, we should advise the company’s management to dismiss this cost-saving project as it won’t be profitable.
Opportunity cost expresses the connection between choice and scarcity. The concept plays a role in ensuring that businesses use limited resources most efficiently. Opportunity cost is essentially the trade-off we make with each choice between alternatives.
The most important takeaway is that opportunity costs represent the notion that every choice has a trade-off connected to it.
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FCCA, FMVA, Co-founder of Magnimetrics
Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.
In my spare time, I am into skiing, hiking and running. I am also active on Instagram and YouTube, where I try different ways to express my creative side.
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The information and views set out in this publication are those of the author(s) and do not necessarily reflect the official opinion of Magnimetrics. Neither Magnimetrics nor any person acting on their behalf may be held responsible for the use which may be made of the information contained herein. The information in this article is for educational purposes only and should not be treated as professional advice. Magnimetrics accepts no responsibility for any damages or losses sustained in the result of using the information presented in the publication.