You make decisions every day: what to eat, what to wear, where to go, and more. The same goes for all you business owners: you make decisions every day on scheduling, staffing, payroll and more.
By making these decisions, you’re actually saying yes to something and no to another.
How do you know you’re making the right decision?
No, we’re not in the business of “going with your gut” when it comes to business.
You need formulaic data: and determining opportunity cost can provide you with just that.
In this article, we’ll look at everything you need to know about opportunity cost and how to use it so that you’re making the best decision for yourself now and in the future.
Opportunity cost: let’s get started!
What is Opportunity Cost?
Why bother with opportunity cost?
Because, my friend, it gives you a superpower — the ability to see the invisible costs lurking behind your every business decision.
We’re talking about those numbers that don’t appear on balance sheets and external financial reports. These aren’t just dollars flying out of your wallet. They’re also opportunities waving goodbye.
Opportunity cost comes in two forms:
- Implicit Costs refer to intangible expenses like the money lost when volunteering instead of working.
- Explicit Costs are more tangible. For example, you’re spending $2,000 on new office equipment instead of investing it elsewhere.
Advantages of Using Opportunity Cost
When you factor in opportunity costs, it can:
- Help you make more informed decisions
- Encourage strategic thinking regarding alternative investments
- Put you a step ahead — it’s like having a cheat code for business
Disadvantages of Opportunity Cost
But there’s a catch. While the costs of opportunity can be your best bud, it also comes with certain challenges:
- Not always easy to quantify because some costs can be difficult to put a number on
- Could lead to overthinking
- Hard to predict future returns on investment
Real-World Examples of Opportunity Cost
Now, let’s get down to brass tacks with some actual scenarios in real estate where this concept is typically used.
- Buying a rental property vs. flipping a house — what profits are you missing out on?
- Choosing to invest in commercial real estate or in residential properties — which one will bring a higher ROI?
- Deciding between reinvesting profits in property improvements and diversifying into stocks — will you stay in your comfort zone or take a risk?
- Choosing among different financing options for new investments — which offers the best terms?
Life’s full of choices, and each one comes with its own set of trade-offs. That’s why opportunity cost can come in handy.
Calculating Opportunity Cost in 3 Steps
Here’s how to calculate opportunity cost for your projects:
Step 1: Pinpoint Your Chosen Option (CO)
Think about what path your heart (or spreadsheet) is set on. The next step might be that new property you’ve been eyeing or expanding your portfolio through crypto.
Step 2: Determine Your Forgone Option (FO)
Your FO is essentially the road not taken. It’s crucial to weigh it against your chosen option.
Consider what you might miss out on by choosing your current path.
It could be an investment in another property type or a completely different business opportunity.
Step 3: Compute the Returns on Both Options
Take into account the potential profits, cash flow, and appreciation for each choice. Think about any expenses, taxes, or fees associated with them as well. By doing so, you’ll have a clearer picture of what each path can offer you financially.
Step 4: Pin Down Your Best Alternative
Compare the potential outcomes of each option. Analyze which one aligns better with your long-term goals and financial strategy.
Weigh the risks and rewards.
Don’t forget to factor in your own comfort level with each scenario.
Once you’ve done this, you’re ready to move forward with confidence.
Step 5: Calculate Your Opportunity Cost
Use this formula:
Opportunity Cost = Return on the Best FO – Return on the CO
Aside from your trusty calculator and handy dandy phone, these are other devices and resources you can use:
- Financial calculators
- Spreadsheet software (everybody loves a good spreadsheet)
- Online investment calculators
These tools will make you feel like a real estate Einstein.
Other Formulas To Use Instead of Opportunity Cost
If the opportunity cost formula doesn’t help you see a clear picture, here are other formulas to conside.r
Cost-Benefit Analysis
Cost-benefit analysis is great when you need a pros and cons list with a twist. Find the sweet spot where costs and revenues see eye to eye.
Sometimes, you might find that good old-fashioned intuition paired with hard data leads to the best outcomes.
Net Present Value
Net Present Value a simple way to figure out how quickly you’ll recover your initial investment. And if you want a broader view, consider the Profitability Index, which can help you gauge the value generated per unit of investment.
Discounted Cash Flow (DCF)
DCF helps evaluate the profitability of future projects. Like peering into a crystal ball of your future cash flow, this is ideal for long-term investment decisions.
Internal Rate of Return (IRR)
IRR is for people who love to geek out on numbers. It’s perfect for comparing the profitability of several investments and handy for capital budgeting.
The Bottom Line: Opportunity Cost
The next time you’re faced with a difficult decision, use the opportunity cost formula from this article to help you make the most profitable decision now and in the future.