What Is Opportunity Cost?

189

In many economic theories, the concept of opportunity cost is used to explain what people should do when in a situation where they should make a certain decision. Opportunity cost is often used to explain the difference between what people should do in certain circumstances and what they would likely be doing if they had chosen differently. One example of this theory is with regards to the decision a company makes to build a factory instead of buying the raw materials that it needs to produce a product. For instance, if the company built the factory instead of buying the raw materials, then they would likely be receiving discounted prices on their products, which they would then be able to pass on to consumers as an added incentive to purchase their products.

In economic theory, opportunity cost refers to the loss or advantage that would have been enjoyed if the most economically feasible option was selected. It is a concept that came from the famous author Aldus Huxley who stated, “So often I have been asked what is the possibility costs, and I answered, nothing. Nothing is certain in this world, except death and taxes.”

This concept is not as easy to explain to a beginner as it is for an advanced economic thinker. For simplicity, let us assume opportunity cost to be the total loss incurred by choosing the wrong investment. We can define it as the difference between what you stand to gain and what you stand to lose. With conventional investment strategies, the opportunities cost are all costs associated with investments. However, there are some implicit costs that are sometimes overlooked.

The cost of hiring new employees is one of the most common forms of opportunity costs. When you hire employees, you pay them. You also pay for their education and training. If your business is on the decline, you may be able to reduce the opportunity cost by focusing on market segments where growth is likely under current circumstances. In such cases, you will not need to make large capital investments. However, you will lose control of how the funds are invested.

The sunk cost of course refers to that part of the capital budget that is not spent today but will be spent later – for example, if you need to buy new equipment. Most of the time, companies spend the sunk cost in order to improve their actual performance. For instance, a company may invest in better quality machinery that lowers the cost of production. This will lower the overall cost of production but will help the company reach its goal.

Fixed cost refers to those investment projects that cannot be altered. These usually include plant and equipment, fixed assets such as building or infrastructure, and capital investments (such as fixed capital and permanent fixtures). While fixed cost can be minimized, it can never be improved. It refers to a situation in which there is a known cost of production and no known benefit from investment projects. There is a great risk that the company may actually lose money if it does not proceed with the investment projects.

One way of minimizing fixed cost is by spreading the fixed cost over a longer period of time – in effect, making larger payments during that period than in a shorter period. However, when a longer period is needed, sunk cost considerations must be taken into account. Here, the question is whether the long-term benefit from investment projects is worth the longer period of time needed for fixed costs to be realized.

What is opportunity cost, then, if a company needs to shift its fixed costs to a short-term goal? This question is especially important for small companies where the owner has a limited amount of capital. Often, a small company’s owner needs to fund a project in order to make it successful. If that project does not go as planned, or if it does not bring in enough revenues to support a move to the next step, then all or some of the fixed cost will have to be refunded. In essence, what is opportunity cost for a small company turns out to be a set of numbers: the more sales achieved at a certain level of investment, the more the fixed cost must be reduced.

What is the opportunity cost for a business also means what is the cost for a business. If the owner knows that the current success of his business is at risk, he should be prepared to take steps to mitigate that risk. Otherwise, the owner may find himself at a loss if, upon being forced out of business, the business fails again because he did not make the effort to better it.