Opportunity Cost Analysis
Opportunity cost analysis is one of the main foundations used in making financial decisions. In strict accounting terms, opportunity cost is not really a cost or an expense. However, it maybe relevant in making decisions with financial repercussions.
Wikipedia says that opportunity cost has been described as expressing the basic relationship between scarcity and choice. When you are torn between making decisions with mutually exclusive results, then one benefit should be sacrificed and that’s the “cost” of choosing one over the other.
Here are some of the examples where opportunity cost analysis comes into play:
You are to make a decision whether to close your business on Christmas and New Year’s Day. Say for example that your projected revenue if you chose to open it would be P2,000 per day. But because of your religious beliefs and your compassion to your employees so as to win their loyalty to the company, you decided to close on both days. In this example, P4,000 was your opportunity cost of closing on both days. It was the sacrifice made to gain some benefit.
Another example where opportunity cost analysis may be relevant is when you decide where to invest your extra cash. Say for example, you are pondering whether to invest it in a riskier type of investment such as stock market vs. a conservative and safe type of investment such as a savings account in the bank. Let’s say that because you fear on losing your money, you decided to just park it in a safe savings account. The opportunity cost here is the possible gain that your money could have earned just in case you decided to invest in stock market.
One more example where opportunity cost analysis comes into play is when you decide whether to scrap or throw away defective appliances or have them fixed for eventual sale.
Deciding whether to offer free home delivery for your food business is another example. In this example, you calculate the delivery costs (gasoline, motor vehicle, etc.) and deduct these from your expected additional revenues due from free home delivery service and the remainder is your opportunity cost. That is the amount you “lost” should you decide not to offer free home delivery (if your expected revenues are higher than your expected delivery costs).
On a personal experience, investing further in the stock market or having my savings just parked in the bank is one of the opportunity costs that I encountered a “loss”. Between the two, I decided to just park it in the bank because back then, my initial stock investments are all experiencing huge losses. Should I decided to invest it in stock market, I should have earned more from it since I’ve never expected that the stock market will rise that fast in just a matter of few months, not years! The possible earnings is the “loss” that I had.
How about you, did you have major experiences where opportunity cost analysis comes into play? Share them below.
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Filed under: Entrepreneurship • Finance Concepts
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2 comments
Tyrone, to complete the opportunity cost analysis, i think we should add in another key figure: reward. In your case, you chose to put money in the bank because u think u would have lose more money in stock. Your cost is the potential gain from stock market gain. But your reward is probably less quantifiable, probably something like peace of mind, more time to write blog instead of watching stock market, etc.
For me there are many opportunity cost involving purely switching stock in stock market, and end up riding on a slower moving train. This could be seen as opportunity cost now but then as i think back about it, i wouldn’t know the right decision to make given my knowledge that time. I call this unknown opportunity cost, simply because at that moment you were probably making the decision u thought was right. However as time goes by, experience accumulated, we will be much better in evaluation this so-called opportunity cost
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Tyrone Reply:
September 13th, 2009 at 12:15 am
Nice insights you have here Zen! You went into detail about opportunity cost of not only investing from one type of investment into another but you concentrated more on the stock market per se.
It’s true that when we educate ourselves more, the more we can choose the best option when presented with opportunities. And in this way, we can minimize the “cost”.
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