In this article we will talk about:
- What is opportunity cost
- Opportunity Cost Example in a Feasibility Study Worksheet
- Because the opportunity cost is important
- Other examples (production frontier)
- Difference between economic and accounting cost
- How to Understand Your Loss in Opportunity Cost
One of the simplest ways to understand whether or not to invest in a business is by doing the economic feasibility study by means of a spreadsheet. See a results tab of our worksheet below:
Understanding the outcome of a feasibility study is essential because this is what will lead you to decide whether or not to invest in it. In the example above, it would be worth investing in the business (through the VPL, IRR and Payback indicators), but there are so many concerns before opening a business or investing in a new equipment or machine that some important points can be overlooked in this process .
For example, even if positive, who guarantees that this is the best investment to make? That is why I say that many entrepreneurs and managers overlook the opportunity cost, an implicit value that will not be demonstrated in a company's accounting reports, but that is very important for its analysis. Check below the meaning of this economic term that is of fundamental importance to compare the feasibility or not of different possibilities of investments in companies.
Opportunity Cost or Alternate Cost are terms used to define the cost of an opportunity that has been overlooked. Basically, it follows the line that one situation was rejected to give room for another. These costs can be both monetary and social, based on the principle that it represents the value associated with the best alternative not chosen. Where there is more than one investment option, it is very important to think of the Cost of Opportunity as the advantage or disadvantage of the choice made.
Let's look at an example of the opportunity cost applied to our Economic Feasibility Study Sheet. Assuming you are analyzing 3 different opportunities to invest your money:
- Opportunity 1: Opening a coffee shop in a neighborhood in the South Zone of Rio de Janeiro
- Opportunity 2: Open a microcredit bank targeting communities in Rio de Janeiro
- Opportunity 3: Opening a clothes trade in a Shopping Center in the West Zone of Rio de Janeiro
If you have done all the work of pre-study and completing the spreadsheet correctly, designing investments, fixed and variable costs, and projecting revenues:
After doing this for each of your possibilities, you had 3 different results:
- Indicators of viability study of investment 1:
- Indicators of viability study of investment 2:
- Indicators of viability study of investment 3:
Based on these indicators, which option would you choose?
In a quick glance, any normal person would discard the third option, which has negative NPV and IRR, meaning they represent a bad investment. But between options 1 and 2, I would certainly hear the answer of opting for the first investment, since it is slightly better than the second option.
Once again we come back to the concept of opportunity cost, because when analyzing an investment, you should not only see the financial indicators (which in this case would get people to the first opportunity). It is important that you analyze a larger context. In our example, what would be the opportunity cost of investing in the 1 business rather than the 2 business?
In a quick way, the 2 business has the ability to positively impact the lives of hundreds or thousands of people in communities. In other words, by failing to invest in it, you would be failing to help large numbers of people and contributing to a better world; on the other hand, you would have a more complex business than a neighborhood coffee shop. In a simplified way, this is the opportunity cost of that choice.
Anyway, there is no right or wrong, just want to make it clear here that when dealing with business, you must use the cost of opportunity within your planning. Simple cost accounting does not consider lost opportunities, but it is essential for anyone who wants to become an entrepreneur or manager to check the best alternative and impact of their decisions in all areas.
- Example 1 - Car Factory x Software
We can think of a company that sells cars. For years, only cars were manufactured in that company, but recently the opportunity arose to manufacture also softwares aimed at the use of vehicles.
Obviously the company can not continue producing its maximum capacity of cars (1000) and nor would it be of interest to only produce software (3000), since the market for cars exists. In this case, the numerical opportunity cost is quite easy to calculate using the production possibilities frontier (FPP) concept:
At point A, 2000 softwares and 700 cars would be produced. In this case, the opportunity cost is 300 cars that will not be produced. Whether the decision is worth it or not is another story. We would need to know the selling prices of each of the products and whether the demand would consume 100% of production or not. At point C we have 200 most software produced by the "cost" of 100 cars.
In this context, point B would indicate a point of inefficiency of production and point D is intangible, since it indicates a production greater than the delivery capacity of that industry.
- Example 2 - Buying a home
Imagine that you want to buy a home and have at hand the full amount to purchase the property. Most people would buy the house even though they knew they would be out of money after the purchase. Considering the opportunity cost is to take into account the possibility of financing the property in good condition, apply the money and, at a profit, pay the installments of the house. That way, you would keep both the property and the money.
There are also other ways of analyzing the opportunity cost of a situation, which can be both investment and financing. When opting for a particular position, it is necessary to analyze what is not included in the contract. A great way to do this is to always ask the following question: how much can I earn if I do not make this transaction or how much can I lose if I do?
It should be taken into account that there are two types of costs within the economy: the accounting cost and the economic cost. The first is characterized by taking into account all the money spent on a particular transaction, that is, a real cost, since it is a real movement of values. The economic, by definition, has the implications that the choices (which have cost) have in the resignation of the opportunity.
Finally, there should be a economic feasibility study before considering any opportunities. Within this study it is necessary to include a projection of costs, investment and an analysis of indicators so that there is greater clarity of the transactions before making a decision.
Questions answered? Leave your comment below!