The Importance of Opportunity Cost in Business

A man making a calculation on a calculator

Economics and business are two disciplines that invariably walk hand in hand, and in the highly complex world of modern commerce, economics can help us understand the key connections between businesses, consumers, states, and other entities.

Therefore, a rudimentary working knowledge of some basic economic principles is essential if you want to achieve success as an entrepreneur, and the concept of opportunity cost is perhaps one of the most fundamental principles that you should understand. 

The Importance of Opportunity Cost

Business and, indeed, by extension – life – is full of difficult choices. As a business owner, you may ask yourself: should I spend x amount now on this new piece of equipment? Or should I save it and wait until costs depreciate and go down? Questions such as these are important to answer, as they can have a significant impact on the operational success of your organisation.

Indeed, such queries are so essential that there is a term given to this particular dilemma: opportunity cost. When you make a choice, it automatically means that you are foregoing something else in its place. For instance, in the example quoted above, if you spend more on buying new equipment, the opportunity cost would be the extra money you could have saved by waiting.

On the flip side, if you took the second option, then you are invoking an opportunity cost of a different sort. Maybe the new equipment in question offers superior efficiency or productivity to your organisation; by waiting for prices to fall, you would have lost out on these benefits. 

Professor Dan Ariely, a well-known author and scholar of behavioural economics, explains it more succinctly: "Money is all about opportunity cost. Every time you spend (it) on something, that's something you can't spend on something else."

The Implications for Small Businesses

Opportunity cost is considered a fundamental principle in economics because it deals with the central problem of scarcity. Virtually everything has a finite value from a business perspective: time; money; labour; resources that you can acquire through a combination of the first three. The smaller you are as a business organisation, the more acute these problems of scarcity are, too. Decisions that you make in the early days of your organisation could either snowball into runaway success or fatal errors later down the line.

This is where measuring and comparing the opportunity cost associated with different actions becomes crucial. It is all about weighing the pros and cons of each business decision. Before allocating your firm's finite resources – be it money, time or labour – it is essential to spend some time considering the risks and rewards.

Measuring the Most Effective Way to Spend

Being frugal is always important when running a small business; after all, cash flow is critical to the immediate survival of your organisation. As we have seen repeatedly – and on a large scale – during the COVID-19 pandemic, having reserves of money in the bank can often be the difference between life and death during a crisis.

But in some situations, cash sitting idly in the bank is, in itself, an opportunity cost. Imagine a situation where you could have used a portion of your savings to buy more advertisements online or expanded your workforce. For a small business, growth is essential for survival, and you often have to be proactive.

As a result, the key lies in identifying opportunities that do not overextend your finances. There is, after all, a difference between smart spending and being wasteful. If you blow all your funds on different marketing platforms, that is a high-risk move that could have severe repercussions.

A smarter decision would be to focus smaller amounts of spending on targeted strategies with a proven return on investment (ROI); maybe email marketing, for example, or print magazine advertising (depending on your target audience). The opportunity cost here is obviously worth it, especially when compared to the more extreme option of blanket spending or, indeed, not spending any money at all. 

Widening Your Knowledge and Making Better Decisions

Of course, it is not always possible to have access to – or be able to contextualise – the bigger picture when making important decisions in business. Often, there are far too many variables, ranging from external factors such as consumer trends, changes in taxes, and natural disasters, to internal factors such as labour shortages, cash crunches or malfunctioning equipment.

Unfortunately, in a lot of cases, you can only develop an accurate idea about the opportunity cost of a decision after that decision has been made. Take the example of fidget spinners, for instance: you may remember that they were something of a popular fad a few years ago. What if you – as many real-life companies did – decide to get on the bandwagon and manufacture them as part of your toy business? This seems like a sound choice; many people would argue this is a textbook case of identifying a lucrative trend and simply attempting to meet consumer demand. But in the case of fidget spinners, the fad died out as quickly as it arose, which would leave you - as it did in real-life for many companies - with a ton of unsold stock.

If you had more in-depth information about fads and consumer preferences, maybe this problem could have been avoided. Rather than blindly following the dollar signs, you may have been a lot more cautious and not ordered too many spinners, instead allocating the remaining resources to a "safer" long-term seller, such as Lego or Barbie dolls.

Considering the opportunity costs involved in each decision encourages you to learn more about the myriad factors involved. It will undoubtedly improve your long-term planning and organising skills – and it ensures that you don't end up with a stock room full of cheap plastic toys that nobody wants.

Enabling Better Management and Ownership

As touched upon, opportunity costs come in many forms – they are not restricted to finance alone. It could be related to how you spend your time – even your personal time. For instance, instead of playing golf every weekend, maybe you might have completed a course. Instead of taking a vacation, perhaps you might have focused on expanding your business network.

Alternatively, the opportunity cost could be staff-related, such as choosing to allocate more labour or work hours to R&D and product development instead of focusing on your current lineup. These are all different types of opportunity costs that cannot be expressed directly in a ledger.

Indeed, only those opportunity costs that involve an outflow of cash from your business will find mention in the account books. Aside from these explicit costs, there are many intangible opportunity costs like the ones mentioned above. It is part of a small business owner or manager's job to focus on identifying and implementing these.

Enabling Better Leadership

Regardless of whether you consider them or not, opportunity costs represent an important part of your business. Taking them to account is almost always beneficial, in multiple ways. Considering all the pros and cons associated with any action will almost always help to mitigate risks, which isn't just desirable – it's a key responsibility that you should take seriously as a business owner.

At the same time, exploring alternatives will often open up bold new avenues for growth and expansion. Ultimately though, the greatest benefit of assessing opportunity costs is this: it will make you a better leader – one who takes each business decision after due consideration. 

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You don't necessarily have to make the right calls all the time; indeed, you won't, as mistakes will inevitably happen in business. But if you have made a decision while taking into consideration all the available data on potential costs and benefits, then you have a better chance of defending yourself in front of your employees, investors, partners, and, indeed, the mirror.

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