Entrepreneur 101: What is Opportunity Cost

From Entrepreneur.com.ph

It simply means the cost of missed opportunity. Scarcity of resources such as time, capital or people forces us to choose something at the cost of giving up another. In business, opportunity cost is always quantified in financial terms, and it is a critical component in every decision making process.

Let’s say your current return on investment is 15 percent annually. This means that if you invested P100,000 in your business at the start of the year, you would earn P15,000 after 12 months from that investment. Suppose a friend of yours wanted to borrow P100,000 from you at an interest of 10 percent a year, would you lend him the money? If you decide to lend your friend the money, even if your accountant would definitely not record any loss in your books  because you would earn 10 percent annually on this loan, you actually would incur an opportunity loss of 5 percent, or P5,000, compared to what you could have earned by just investing the money in your business. Your opportunity cost of 15 percent would be simply higher than a return of 10 percent; therefore, you should not lend your friend the money.

Take another example. Let’s say you owned office space that you use for the business. Does this mean that you should rejoice when your accountant reports that your rent expense is zero? Assume that your monthly income is P40,000 and that you could actually rent out that office for P50,000. If you consider your opportunity cost, then you might want to rent out that space instead.

If you are engaged in retailing, one of your biggest concerns must be inventory. Rising inventory levels in the face of weakening sales growth might not immediately affect your net profit but could create significant opportunity costs to you. Why? When your inventory is not moving, you are not able to convert your merchandise stocks into cash, thereby getting your capital tied up indefinitely. If the amount of your inventory is P500,000 and the current interest rate in the bank is 8 percent, your opportunity cost is P40,000 (8 percent of P500,000)—you could have converted your inventory to cash and deposited it into high yielding commercial paper, giving you in this case 8-percent interest.

Your opportunity cost will be higher if you used your cash to invest in an instrument with higher returns. For example, if you are given the opportunity to invest in another business that guarantees annual returns of 20 percent a year, then the opportunity cost will be P100,000 (20 percent of P500,000).