Definition
The cost of passing up the next best choice when making a decision. For example, if an asset such as capital is used for one purpose, the opportunity cost is the value of the next best purpose the asset could have been used for. Opportunity cost analysis is an important part of a company’s decision-making processes, but is not treated as an actual cost in any financial statement.(“Opportunity cost Definition,” n.d.).
The concept of opportunity cost is important in making any decision, personal or professional, because it captures both the cost of making a choice, and the cost of the next best alternative. If the alternative choice will produce revenues, they should also be included.
Also note that opportunity cost rises as the number of proposed goods or services rises. In other words, there is always a point where it makes little sense to invest more treasure in anything at the expense of something else.
It is a great idea to get in the habit of considering all important life decisions through the filter of opportunity cost. Most of us already do even if we don’t ascribe a monetary value. For instance, it is my personal opinion that dish washers could cost more since they mitigate the opportunity cost of cleaning up. Or, given the choice of staying at work or having dinner with your partner, which do you choose? If you stay at work when your partner is expecting you, the opportunity cost may be very, very high. Certainly you take that into account, and therefore most often disappoint your boss instead.
Examples
Sheila decides to get an MBA. The cost of two years at college includes tuition, rent, books, etc. But that is not the total real cost. The opportunity cost is the net wages she would have accrued during those two years minus her present expenses.
If Sheila wished to determine if the MBA has a monetary payback (was worth it monetarily), she would weigh these opportunity costs against a realistic projection of her future wages after graduation. She could also consider the intrinsic satisfaction of having a graduate degree, although they are not necessarily quantifiable.
In Mark’s case, he is considering putting a $50,000 addition on to his house. His opportunity cost is the the realistic, best alternative use of his $50,000. For some people, that might be a money market account at say, 3% interest. For others, it might be investment in stocks at a long term return of 5%. For Mark, who has some extra time and management experience, the best alternative is putting a down payment on a rental property which would generate a $500 per month positive cash flow after rental income less maintenance and mortgage costs are taken into account. Notice that Mark should estimate appreciation on both alternatives.
Discounted Cash Flow
A popular use of opportunity cost is the Discounted Cash Flow, where a capital investment is offset or ‘discounted’ by the interest the cash would have earned over the life time of the investment (“Opportunity cost | Economist.com,” n.d.)
The calculation is available on the internet as formulas and spreadsheet templates, and many calculators have the calculation built into them. Larger projects become more complex with supporting schedules outlining detailed project costs as well as interest calculations. Especially on larger business projects I prefer outlining alternative uses other than just interest rates if at all possible since the returns on cash are a meager use of shareholder capital; at the least the discount rate should be the cost of eliminating existing debt.
References
Opportunity cost | Economist.com. (n.d.). Economist. Retrieved August 17, 2009, from http://www.economist.com/research/Economics/searchActionTerms.cfm?query=opportunity+cost.
Opportunity cost Definition. (n.d.). Investor Words. Retrieved August 16, 2009, from http://www.investorwords.com/3470/opportunity_cost.html.
Buchanan, James M. Cost and Choice: An Inquiry in Economic Theory. Liberty Fund Inc., 1969. http://www.econlib.org/library/Buchanan/buchCv6c0.html#Preface. Strongly recommended.
