Understanding opportunity cost in business and how to calculate it

What is an opportunity cost?

At its core, opportunity cost is the value of the next-best alternative that you give up when you make a decision. It’s the "road not taken" in business terms. It’s not just about the money you spend; it’s about the potential benefits you miss out on by choosing one option over another 2.

To better understand the concept, imagine you have a spare HK$50,000 in your business account and 2 primary options:

• Invest in a new marketing campaign projected to increase sales by 10%.
• Upgrade your production equipment to increase efficiency by 15%.

If you choose to launch the marketing campaign, the explicit cost is the HK$50,000 you spend. However, the opportunity cost is the 15% efficiency gain you could have achieved by upgrading your equipment. Conversely, if you choose the equipment upgrade, your opportunity cost is the potential 10% sales growth from the marketing campaign.

This concept applies to every resource, not just capital. The time your team spends on Project A is time they can't spend on Project B. The factory space used to produce a product can't be used to produce another.

Opportunity cost forces you to look beyond the obvious expenses and consider the hidden value of the alternatives you forgo. It is the real, albeit often unseen, cost of any choice ³.

Why is opportunity cost important for your business?

Integrating opportunity cost into your decision-making framework is crucial for several reasons. It elevates your strategic thinking from simple accounting to true economic analysis, leading to more robust and sustainable growth.

• Better resource allocation: Every business operates with finite resources. Opportunity cost provides a clear lens through which to evaluate where your capital, labour, and time will generate the most value. It helps you answer the critical question: "Is this the absolute best use of our resources right now?"
• Informed investment decisions: When comparing potential investments or projects, looking only at the projected return of each in isolation is a common mistake. By calculating the opportunity cost, you can directly compare the relative value of different options. This ensures you’re not just picking a good investment, but the best available investment.
• Accurate profitability assessment: As we'll explore later, opportunity cost is the key differentiator between accounting profit (the numbers on your income statement) and economic profit (the true measure of profitability). A business might be making an accounting profit but an economic loss, meaning its resources could be generating more value elsewhere. Understanding this can prevent you from continuing a venture that is underperforming relative to its potential.
• Enhanced strategic planning: From pricing strategies to market entry decisions, opportunity cost plays a vital role. For example, pricing a product too low might increase sales volume, but the opportunity cost could be the higher profit margin you could have earned with a different pricing strategy. Considering these trade-offs leads to more sophisticated and effective long-term plans.

Ultimately, consciously considering opportunity cost helps to cultivate a culture of efficiency and critical evaluation. It encourages you to justify your decisions not just on your own merits, but in comparison to all other viable alternatives, thereby maximising the company's overall potential ².

Understanding types of opportunity costs

To fully grasp opportunity cost, you also need to understand its components. The total opportunity cost of a decision includes both the tangible, out-of-pocket expenses and the intangible, forgone benefits. These are categorised as explicit and implicit costs ⁴.

Explicit costs

Explicit costs are the most straightforward and familiar type of business expense. They represent all the direct, out-of-pocket payments a company makes to run its operations. These are the costs that are recorded by accountants, appear on financial statements like the income statement and balance sheet, and are used to calculate accounting profit.

Examples of explicit costs include ⁵:

• Wages and salaries paid to employees
• Rent for office or factory space
• Payments for raw materials and inventory
• Utility bills (electricity, water, internet)
• Marketing and advertising expenses
• Insurance premiums
• Equipment purchases

These costs involve a clear transaction of money from the business to another party. While they are a crucial part of any business analysis, they only tell half of the story.

Implicit costs

Implicit costs, also known as implied or notional costs, are more subtle. They represent the value of resources the company owns and uses for its operations, for which no direct monetary payment is made.

In essence, an implicit cost is the opportunity cost of using an asset or resource for one purpose instead of another. These costs are not tracked in standard accounting practices but are vital for making sound economic decisions.

Examples of implicit costs include ⁶:

• Owner's forgone salary: An entrepreneur who starts a business forgoes the salary they could have earned working for another company. If a founder could earn HK$100,000 per year as an employee elsewhere but instead runs their own company, that HK$100,000 is an implicit cost of the venture.
• Use of owned assets: If you run a business out of a building you own, you don’t need to pay rent (an explicit cost). However, the implicit cost is the rental income you forgo by not leasing the building to another tenant.
• Depreciation of capital: While accounting depreciation is recorded, the economic depreciation (the loss in market value of equipment due to use) is an implicit cost of production.
• Return on invested capital: The capital invested in the business could have been invested in stocks, bonds, or real estate, earning a return. This forgone investment income is an implicit cost.

The total opportunity cost of any decision is the sum of both explicit and implicit costs. By considering both, you get a complete picture of the true economic cost of your choices 4.

How to calculate opportunity costs

While the concept can seem abstract, the formula for calculating opportunity cost in financial terms is quite simple. It involves comparing the return from the chosen option with the return from the best-forgone option.

The formula is ^2,7:

Opportunity Cost = Return of the Most Profitable Alternative (Forgone) − Return of the Chosen Alternative

Let's break this down:

• Return of the Most Profitable Alternative (Forgone): This is the value or benefit you would've received from the next-best choice you did not make.
• Return of the Chosen Alternative: This is the value or benefit you expect to receive from the decision you actually made.

The goal is to understand what you're sacrificing. If the result is positive, it represents a net loss in potential value from your decision, even if the chosen option is profitable. The ideal scenario is to choose the option with the highest possible return, making the opportunity cost of choosing any other option a tangible figure representing lost potential. It’s important to ensure that the returns for both options are calculated over the same time period for an accurate comparison ².

Examples of calculating opportunity costs in business operations

Let's apply the formula to some common business scenarios.

Scenario 1: Capital investment

A software company has HK$200,000 in cash reserves. It is considering two projects:

• Option A: Develop a new mobile app, with a projected annual return of HK$30,000 (a 15% return).
• Option B: Invest in upgrading its existing software, with a projected annual return of HK$24,000 (a 12% return).

The company chooses to develop the new mobile app (Option A). To find the opportunity cost, it identifies the chosen option's return and the forgone option's return.

• Return of Chosen Alternative (A): HK$30,000
• Return of Forgone Alternative (B): HK$24,000

The opportunity cost here isn't simply the return of Option B. The opportunity cost is the net benefit of the next best alternative. In this case, since the company chose the more profitable option, the opportunity cost analysis validates the decision. However, if the company had chosen Option B, the calculation would be:

• Opportunity Cost = HK$30,000 (Return of A) − HK$24,000 (Return of B) = HK$6,000

By choosing the upgrade (Option B), the company would incur an opportunity cost of $6,000 in lost potential profit per year ².

Scenario 2: Resource allocation decisions

A bakery has enough oven capacity, ingredients, and labour to bake either 100 cakes or 400 loaves of bread in a day.

• A cake sells for a profit of HK$20. Total potential profit: 100 × HK$20 = HK$2,000.
• A loaf of bread sells for a profit of HK$6. Total potential profit: 400 × HK$6 = HK$2,400.

The bakery decides to bake 100 cakes.

• Return of Chosen Alternative (Cakes): HK$2,000
• Return of Forgone Alternative (Bread): HK$2,400
• Opportunity Cost = HK$2,400 − HK$2,000 = $400

By choosing to bake cakes, the bakery has an opportunity cost of HK$400 in profit it could have earned by baking bread instead. This analysis shows that focusing on bread production would be the more profitable use of its resources ^1,2.

Opportunity cost vs other costs

To use opportunity cost effectively, it's important to distinguish it from other related financial concepts.

Opportunity cost vs sunk cost

This is one of the most critical distinctions in business strategy.

• Sunk Cost: A cost that has already been incurred and can;t be recovered, regardless of future decisions. Examples include money spent on past market research, non-refundable deposits, or initial training for a cancelled project.
• Opportunity Cost: A forward-looking cost that represents the potential benefit of a future choice not taken.

The key difference is timing and relevance. Sunk costs are in the past and should be ignored when making current or future decisions. This is known as the "sunk cost fallacy"—the tendency to continue a project or investment just because you've already invested resources in it. Opportunity costs, on the other hand, are entirely about the future and are central to making the right decision moving forward ⁸.

Example:

You spend HK$10,000 developing a prototype for a new product. That HK$10,000 is a sunk cost. Now, you discover a competitor is launching a superior product. The decision to continue or abandon your project shouldn't be based on the HK$10,000 already spent, but on the future potential for profit versus the opportunity cost of investing your future time and money into a different, more promising project.

Opportunity cost vs marginal cost

• Marginal cost: The cost of producing one additional unit of a good or service. It's an incremental cost focused on production volume. For example, if it costs $100 to produce 10 widgets and $108 to produce 11 widgets, the marginal cost of the 11th widget is $8.
• Opportunity cost: A broader concept that applies to any choice, not just production levels. It compares entire alternatives.

The two are related. The resources used to produce one more unit (the marginal cost) have an opportunity cost—they could have been used to produce something else. However, marginal cost is specifically used to determine the optimal level of production (producing until marginal cost equals marginal revenue), while opportunity cost is used to decide between entirely different strategic paths (e.g., producing widgets vs. producing gadgets) ⁹.

Opportunity cost vs risk

These two concepts are often intertwined in investment decisions, but are distinct.

• Risk: The uncertainty and potential for loss associated with a decision. It deals with the variability of potential outcomes. An investment might have a high expected return, but also a high risk of returning nothing at all.
• Opportunity cost: The certain benefit forgone from the next-best alternative. It assumes a known or expected return from the forgone option.

Risk is about the "what ifs" of a chosen path, while opportunity cost is about the value of the path not taken.

When evaluating a high-risk, high-reward investment, the opportunity cost is often the return from a safer, lower-risk investment such as a government bond. A wise decision-maker must assess if the potential reward of the risky option sufficiently compensates for both the inherent risk and the opportunity cost of foregoing a safer return ¹⁰.

Opportunity cost vs trade-offs

This is a subtle but important distinction.

• Trade-off: A situation that involves losing one quality or aspect of something in return for gaining another quality or aspect. It's the act of choosing itself, forced by scarcity. For every decision, there is a trade-off.
• Opportunity cost: The tool used to measure the cost of that trade-off. It quantifies what is being sacrificed.

In short, "trade-off" is the general concept of having to choose between alternatives. "Opportunity cost" is the specific value of the most desirable alternative you give up in that trade-off. For example, you face a trade-off between working and leisure; the opportunity cost of an hour of leisure is the wage you could've earned in that hour ³.

Understanding the concept of accounting vs economic profit

The inclusion of implicit costs creates a crucial distinction between how accountants and economists view profit. This is why there are 2 types of profit you should consider when running a business: accounting profit and economic profit.

What is accounting profit?

Accounting profit is the figure you see on a company's income statement. It's a measure of financial performance based on the rules of accounting.

The formula is straightforward: Accounting Profit = Total Revenue − Explicit Costs

It calculates profit by subtracting only the direct, monetary costs from total revenues. This figure is essential for tax purposes, reporting to shareholders, and securing loans.

What is economic profit?

Economic profit, on the other hand, provides a deeper analysis of a company's financial health and the efficiency of its resource allocation. It considers both explicit and implicit costs.

The formula is: Economic Profit = Total Revenue − (Explicit Costs+Implicit Costs)

Alternatively: Economic Profit = Accounting Profit − Implicit Costs

If your company achieves zero economic profit (or "normal profit"), it means that your total revenue is exactly covering all explicit and implicit costs. You're earning just as much as you would in your next-best alternative. There’s no economic reason to exit the industry, but there’s also no extra incentive for new companies to enter ¹¹.

Example of accounting profit vs economic profit

Up to this point, you may already understand the difference between accounting profit and economic profit. But do you really need to use both when making decisions? To answer that, let’s look at an example:

A freelance graphic designer generates HK$150,000 in revenue in a year. Her explicit costs for software, marketing, and office supplies are HK$30,000.

• Accounting Profit: HK$150,000 − HK$30,000 = HK$120,000.

Now, let's consider her implicit costs. To run her business, she gave up a full-time job that paid an annual salary of HK$95,000. This forgone salary is her primary implicit cost and can be used as a variable in calculating her economic profit.

• Economic Profit: HK$150,000 − (HK$30,000+HK$95,000) = HK$150,000 − HK$125,000 = HK$25,000.

While her business shows a healthy accounting profit of HK$120,000, her economic profit is only HK$25,000.

This figure tells a more complete story: she is HK$25,000 better off running her own business than she would be in her next-best alternative (the salaried job). If her economic profit were negative, it would be a strong signal that her resources (her time and skills) could be used more profitably elsewhere, even if her business is technically "in the black."

Streamline your expense management with Aspire

Understanding the complex interplay of explicit, implicit, and opportunity costs is the hallmark of a savvy business leader. While grappling with the strategic implications of opportunity costs is a high-level task, it rests on a foundation of solid financial data.

You can’t identify where your resources could be better allocated if you don’t have a clear picture of where they’re going now. That’s why managing your explicit costs is the first and most critical step in building reliable financial data.

However, from our experience, we’ve seen that new businesses often struggle to track and monitor expenses, which can lead to poor decision-making and overspending. These challenges usually stem from manual processes, which may result in duplicate entries or incorrect expense amounts.

This is where Aspire’s Expense Management can help. It streamlines your overall expense management so you gain a clear, real-time view of your actual business expenses. With Aspire’s Expense Management, you can:

• Set spending limits at the client, budget, or team level and monitor these expenses in real time, ensuring they stay aligned with the budget.
• Review, approve, and disburse claims from one dashboard. Employees can submit claims within seconds by scanning receipts via the Aspire mobile app, ensuring that no receipt is missed.
• Democratise the purchasing process by issuing unlimited corporate cards to team members. You can set spend limits and assign each card to a specific merchant or project, helping you avoid unauthorised transactions or overspending.

When your explicit costs are tracked, categorised, and analysed with precision, you free up invaluable time and mental energy. This clarity enables you to move beyond day-to-day financial management and focus on the bigger picture: making strategic decisions that minimise opportunity costs and maximise your company’s growth potential.