Simply stated, an opportunity cost is the cost of a missed opportunity. Applied to a business decision, opportunity cost might refer to the profit a company could have earned from its capital, equipment, and real estate if these assets had been used in a different way. The concept of opportunity cost may be applied to many different situations. It should be considered whenever circumstances are such that scarcity necessitates the election of one option over another. Opportunity cost is usually defined in terms of money, but it may also be considered in terms of time, person-hours, mechanical output, or any other finite, limited resource.
Although opportunity costs are not generally considered by accountants—financial statements only include explicit costs, or actual outlays—they should be considered by managers. Small business owners should factor in opportunity costs when computing their operating expenses in order to provide a bid or estimate on the price of a job. Opportunity costs increase the cost of doing business, and thus should be recovered as a portion of the overhead expense charged to every job. Ignoring opportunity costs may lead small business owners to undercharge for their services and overestimate their profits.
EXAMPLES OF OPPORTUNITY COSTS
One way to demonstrate opportunity cost lies in the employment of investment capital. For example, a private investor purchases $10, 000 in a certain security, such as shares in a corporation, and after one year the investment has appreciated in value to $10, 500. The investor's return is 5percent. The investor considers other ways the $10, 000 could have been invested, and discovers a bank certificate with an annual yield of 6 percent and a government bond that carries an annual yield of 7.5percent. After a year, the bank certificate would have appreciated in value to $10, 600, and the government bond would have appreciated to $10, 750. The opportunity cost of purchasing shares is $100 relative to the bank certificate, and $250 relative to the government bond. The investor's decision to purchase shares with a 5percent return comes at the cost of a lost opportunity to earn 6 or 7.5 percent.
Expressed in terms of time, consider a commuter who chooses to drive to work, rather than using public transportation. Because of heavy traffic and a lack of parking, it takes the commuter 90 minutes to get to work. If the same commute on public transportation would have taken only 40 minutes, the opportunity cost of driving would be 50 minutes. The commuter might naturally have chosen driving over public transportation because he could not have anticipated traffic delays in driving. Once the choice has been made to drive, it is not possible to change one's mind, thus the choice itself becomes irrelevant. Experience can create a basis for future decisions, however: the commuter may be less inclined to drive next time, knowing the consequences of traffic congestion.
In another example, a small business owns the building in which it operates, and thus pays no rent for office space. But this does not mean that the company's cost for office space is zero, even though an accountant might treat it that way. Instead, the small business owner must consider the opportunity cost associated with reserving the building for its current use. Perhaps the building could have been rented out to another company, with the business itself relocated to a location with a higher level of customer traffic. The foregone money from these alternative uses of the property is an opportunity cost of using the office space, and thus should be considered in calculations of the small business's expenses.