Opportunity Cost & Critical Business Decisions
What Does Opportunity Cost Mean?
It’s the cost of an alternative that must be forgone in order to pursue a certain action. Put another way, the benefits you could have received by taking an alternative action.
The difference in return between a chosen investment and one that is necessarily passed up. Say you invest in a stock and it returns a paltry 2% over the year. In placing your money in the stock, you gave up the opportunity of another investment – say, a risk-free government bond yielding 6%. In this situation, your opportunity costs are 4% (6% – 2%).
Investopedia explains Opportunity Cost
The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose four years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages.
Opportunity Cost: A Simple Business Example:
If a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.).
In both cases, a choice between two options must be made. It would be an easy decision if you knew the end outcome; however, the risk that you could achieve greater “benefits” (be they monetary or otherwise) with another option is the opportunity cost. Read more
Even the “do nothing” or “change nothing” option involves opportunity cost… “do nothing” has a zero incremental benefit because it reflects the status quo. Rational decision making behavior includes a comprehensive evaluation of the monetary effects of all alternative courses of action.*
It is imperative to understand that nothing is free. No matter what one chooses to do, he or she is always giving something up in return. An example of opportunity cost is deciding between going to a concert and doing homework. If one decides to go the concert, then he or she is giving up valuable time to study, but if he or she chooses to do homework then the cost is giving up the concert. Opportunity cost is vital in understanding microeconomics and decisions that are made.
* Cost Accounting: Foundations and Evolutions By Michael R. Kinney, Cecily A. Raiborn