What is Opportunity Cost

The opportunity cost of a decision is the inherent value of whichever option is not chosen (typically referred to as the ‘next best alternative’), which is therefore sacrificed. For example, a solopreneur is selling their digital real estate. They must decide between selling it themselves and enlisting an M&A broker. If they choose to sell it themselves, the opportunity cost is the broker’s value: hundreds of hours the solopreneur would have saved, experience leveraging a higher sale price, an expert website valuation using industry benchmarks, and a quicker exit. If the broker is chosen, the opportunity cost to the business owner will be potential returns from investing the broker’s commission, for example by seeding their next venture or in the stock market.

As in the above example, opportunity cost is typically represented in terms of resources like money or time. This is arguably the most important economic concept an entrepreneur must learn. Business owners must routinely determine their opportunity cost when weighing decisions to maximize their future returns. Understanding opportunity cost leads to better decision-making, which helps digital business owners prioritize their limited resources efficiently and effectively

You can calculate your opportunity cost using this simple formula: Opportunity cost = value of the next best alternative choice – the value of your choice.

Key Points About Opportunity Costs

• There’s no such thing as a free lunch: Everything has a cost, even if advertised as “free.” This hidden cost is the opportunity cost.
• Sunk cost: Unlike opportunity costs, which are future costs the decision-maker has not faced yet, sunk costs are in the past. This is money a decision-maker has already spent and cannot get back.
• Opportunity cost vs. risk: Risk relates to the probability the desired projected outcome of a decision will actually manifest. In other words, risk weighs the probability of the desired predicted outcome against other undesired outcomes. In contrast, opportunity cost compares the projected trade-off between two decisions. Estimating risk while evaluating opportunity costs provides a more accurate picture when weighing decisions. For example, entrepreneurs typically maintain ample cash reserves to pay bills in the event of slow cash flow fiscal quarters. They consider risk when weighing the likelihood of high inflation vs. slow cash flow during economically turbulent times.
• Future value of money: The concept that a sum of money today is worth more than the same amount of cash in the future. When considering opportunity costs, the future value of money is the potential return which could be earned if the funds were invested elsewhere. For example, the money could have been invested in something that generates compound interest over time.