Opportunity cost is the figurative cost incurred when money is invested in a specific opportunity versus other available alternatives.
Opportunity cost is the concept that investing in an opportunity excludes investing in other opportunities. And if other opportunities had offered better returns, the difference between the two is known as the opportunity cost.
Equation
Benefit of most profitable alternative – Benefit of opportunity = Opportunity cost
Example
A roof cleaning company has £20,000 in retained profits and are decided on whether to invest the capital in either:
- a vehicle mounted aerial platform (“cherrypicker”)
- marketing and lead generation
Option 1
They choose option 1: the cherry picker. And through this, they manage to win a council tender contract to clean local authority buildings over 5 years. The tender is worth £220,000 in new business revenue.
Option 2
Option 2 was to invest £2,000 in Google cost per click advertisement, which the company refused in favour of option 1. Their marketing manager estimated that the cost per click in such an advertising campaign would be £1 per potential customer clicking to the company website. The estimated conversion rate of potential customers who visit the website via this campaign who actually hire their cleaning services is 0.5%. With an estimated revenue per job of £5,000, the total potential revenue from this campaign is £50,000:
£20,000 @ £1 per click
= 20,000 clicks (to their website from Google)
@ 0.5% conversion rate
= 10 customers gained
@ £5,000 per customer
= £50,000 in new sales revenue
Calculation
The company would be better off by £170,000 if they chose option 1.
Whereas the opportunity cost of option 2 would be £170,000 in revenue.
Considerations
Importance
Opportunity cost is an important component of alternatives analysis, where deciion makers weigh up the financial benefit/cost of selecting each alternative investment opportunity.
Guidance
Opportunity cost should be a guiding principle in investment decision making. However, like many frameworks for decision making it isn’t perfect – it has flaws. Like in the example above, actual advertising rates during a can vary affecting overall cost and return on investment.