Opportunity cost is the potential profit that an individual, investor, or business loses when choosing one alternative over another. Since by definition they are invisible, these costs can easily be ignored if not careful. Understanding the potential for missed opportunities by choosing one alternative over another allows for better decision-making, especially with the help of an accounting system.
Financial reports often don’t show this factor, but business owners still use the concept to make smart decisions when they have many choices beforehand.
Why is opportunity cost important?
Even though it is not a concept in accounting, so it does not appear in financial records, it is influential in making important decisions. An indicator of good planning is with proper management of opportunity costs as well as in detail.
This factor includes all expenses for making one choice over another, including lost time, energy, and acquired utility. This is very important in making wise decisions. It does not have to be in the form of money, but also in the form of time or benefits that will be obtained in the future.
Here are some of the benefits of knowing opportunity costs
Awareness of missed opportunities
With the opportunity cost, you will consider the fact that when you make a choice, you have to sacrifice other options. This helps make more economically accurate decisions that maximize your resources.
Some would argue that opportunity costs are not “real” costs because they do not appear directly on a company’s financial statements. Because it is a relatively abstract concept, many companies, executives, and investors fail to take it into account in their day-to-day decision-making. However, in the long run, the opportunity cost can have a very large effect on the results achieved by individuals or companies.
Knowing relative prices
Another important benefit of considering opportunity cost is that it allows you to compare the relative prices and benefits of each option. Compare the total value for each option and decide which one offers the best value.
Help set priorities
In determining the priority scale, the more profitable the economic value of a business opportunity is, the greater the chance to be elected. You can choose which alternative is the most important and profitable based on the circumstances and business needs.
How do you calculate it?
Use this simple formula to calculate the opportunity cost of potential business investment:
OPPORTUNITY COST = RESULT OF OPTION A – RESULT TO OPTION B
Although the formula is simple, sometimes it is not easy to determine the variable by factors that cannot be converted into values such as risk, time, skills, or effort.
An investor is interested in buying shares in Company A or Company B.
The expected return on investment for Company A’s shares is 20% over the next year. It is in a stable industrial environment with no short or long-term threats.
Company B’s shares are expected to return 35% over the next year. The proposed industry regulations threaten the long-term survival of the company, but they may not be passed.
Opportunity cost = Firm A – Firm B
= 20% – 35%
The opportunity cost is a difference of fifteen percentage points. In other words, if investors choose Company A, they are giving up the opportunity to make a better return on the stock market conditions. While some investors want the safest returns, others aim for the highest yields. This investor chooses a riskier option.
Although this cost is not a concept in accounting, so it does not appear in an entity’s financial records, it is important in the decision-making process. An indicator of good planning is with proper management of opportunity costs as well as in detail.
Given the importance of calculations such as opportunity costs in a business, you can take advantage of specialized accounting software.