Opportunity cost: What is it and how does it affect business decisions?

Opportunity cost is a concept in business and economics which looks at the costs of decisions you didn’t take and alternatives you didn’t pick.

It’s the costs of dedicating your time and resources to one alternative over another - the costs of what might have been, versus the costs or profits of the decision you did make.

Opportunity cost is an important concept in smart and data driven business decision making. It’s especially important that small business owners and newer entrepreneurs understand the meaning of opportunity cost, as it can be a powerful way to make the most of every cent (and every minute) you spend on growing your company.

In this article, we’ll cover:

What is opportunity cost?

Opportunity cost is the cost of picking one alternative in a business decision as opposed to the other possible alternative.

To give a really simple example, let’s say you’ve just launched a Singapore business selling clothing. You have 1,000 SGD left in your budget, and you’re trying to decide whether to spend that on new stock to sell later, or on marketing to give your business a boost today.

If you spend the 1,000 dollars on new stock you can’t benefit from the marketing opportunity - and vice versa. Plough your remaining funds into marketing and you can't replenish your stocks immediately.

Opportunity cost is the difference in the profit (or loss) you could make by choosing one opportunity over another.

Opportunity cost is especially relevant to newer and smaller organisations which may have more limited resources compared to big established corporations. It’s more important than ever that you make the most possible return from every decision when you’re just starting out.

How to calculate opportunity cost

The basic opportunity cost formula is as follows:

Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue

In this formula we’d try to ascribe numbers to both possible choices using sensible assumptions and the data we have.

In our example above, perhaps we predict that by investing our remaining budget in marketing, we’ll sell 80% of the stock we already have on hand, generating a total profit of 3,000 SGD.

If we use the money to buy additional stock and rely on free word of mouth marketing instead, perhaps we'll sell only 50% of the total stock we have, but generate a profit of 3,500 SGD because we’ve actually got far more stock on hand to sell.

In this case, the opportunity cost is the difference between the two - so we’d be up by 500 SGD if we bought more stock, but would have missed out by 500 SGD if we went with paid marketing.

Of course, often the true opportunity cost of a decision can’t be known until after the event, if at all. But by taking time to think through the possibilities of different alternatives in a decision, in terms of the possible cost and return, you can improve your decision making and feel more confident in your business planning.

How opportunity cost affects business decisions

If you’re faced with a tricky business decision, you could assess opportunity costs in these broad steps:

1. Generate a long list of possible options based on the decision you’re making
2. List out the costs and benefits (profit or non financial benefits) associated with each option
3. Calculate the opportunity value of each using the opportunity cost formula
4. Compare the alternatives based on the opportunity value you’ve calculated

Of course, when it comes to real life business decision making it’s not always this simple. You can’t always exactly predict or assess the financial costs and opportunities based on future events.

Opportunity cost business decision making can help balance out the objective and calculable risks and benefits of a decision, as well as the more intuitive, speculative or gut feel elements of decision making. You can take into account both absolute numbers where you have them, and your planned business strategy, future growth and so on, to come up with a good balance of data and information to base your decision on.

Opportunity cost example

Let’s look at an opportunity cost example where a local Singapore business - Novelship - made a calculated decision based on opportunity cost, to rely on Wise Business for international financial services.

Novelship is an innovative online marketplace for authentic sneakers, apparel and collectibles, popular with enthusiasts and collectors around the world. Novelship was founded in Singapore - but curates their collection by buying from suppliers all around the world. This means paying suppliers overseas in foreign currencies, and in a highly competitive niche, building trust with key suppliers by making timely and efficient payments every time.

Novelship started out using their business bank account to transfer money to overseas suppliers. This is reliable and familiar, so not a surprising place to start. However, when Novelship’s founders realised they were paying more than they had to in fees - and missing trust-building opportunities with their suppliers thanks to payments that took days to settle - they started to look at alternatives.

Ultimately, Novelship decided to move their international payment functions to Wise Business. While there’s a cost in changing your process - including a one time fee for a Wise Business account, and the time it takes to alter your set up and start to pay a different way - the opportunity cost analysis worked out in Wise’s favour.

In the end, Novelship founder Richard Xia believes the team have saved around $20,000 and 20 hours per month by moving from their bank to Wise Business - a boost any growing business would be grateful for.

➡️ Read more about how Novelship used Wise Business to tap into a global opportunity.

Opportunity cost vs other costs

Of course, opportunity cost isn’t the only thing to think about. You’ll know as a business owner that all decisions must take into account a very broad range of factors which can influence the outcome.

Let's look at the difference between opportunity cost and some other business costs commonly used in business decisions:

Sunk cost - sunk cost is the amount of money you’ve already put behind a business decision or direction. Sunk cost might be money invested in machinery or equipment, or in buying stock for your business to sell, for example. This is money you can’t get back, so you need to take it into account before deciding to switch direction as it may result in a loss.

Marginal cost - marginal cost is the cost of creating one extra unit of an item for sale. If producing more items means that the cost of each item comes down, it may be worth getting behind an increase in volume. However, calculating the marginal cost will help you decide at what point increasing production will result in an increased profitability.

Incremental cost - incremental cost is somewhat similar to marginal cost, looking at the cost to increase production capacity by leaps of more than one unit at a time.

Limitations of opportunity cost

Ultimately your business decision making will be driven by many factors including opportunity cost and the other measures of cost outlined above. Opportunity cost alone won’t be enough in many cases - it’s also got a few important limitations:

Opportunity cost calculations can be subjective - you’ll be working with data based on assumptions in many cases, rather than absolute fact, which can make your cost calculations subject to errors or bias

Opportunity costs can be difficult to quantify - costs aren’t necessarily financial, which can then feel much more abstract when analysing. Opportunity costs can also be impacted by your preferences and projections for future growth of your business, as well as your business strategy and ethos

Opportunity costs can be hard to record - with projected outcomes and a mix of financial and non-financial measures, you might struggle to come to an out and out decision about alternatives based on opportunity costs alone

Opportunity costs can’t cover all the factors which might change a decision’s outcome - business environments can be messy, so changes in the economy, in public policy, in consumer confidence and other factors can also be a huge driver of outcomes, and can’t always be predicted

Conclusion

Understanding the meaning of opportunity cost is useful when making business decisions. It’s not likely to be the only factor you take into account when making a big business decision - but having this analysis to hand when you choose between alternatives can give depth and data to your decision making process.

Opportunity costs could also be about fees you paid unnecessarily.

If you’re running a Singapore business which has customers, suppliers or employees overseas, the costs of foreign exchange can quickly become a burden if you don’t find the right way to keep on top of your international business finances.

Check out Wise Business which can help you cut the costs of transacting overseas. Wise uses the mid-market exchange rate for currency conversion and charges super low transfer fees — saving businesses money every month: money that can be redeployed to grow your business elsewhere.

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