Opportunity cost is the ‘cost’ of having to give up something else you could be doing instead.
Soccer or Volleyball?
Say you have two choices for after-school sports: soccer and volleyball. Both are free, so the ‘cost’ of each is really the opportunity cost: if you play one, you won’t be able to play the other. You won’t be hanging out with those other kids. You won’t be improving at the other sport. And if that other team reaches the finals, you won’t be going.
In business, ‘opportunity cost’ is always important, because most businesses have more opportunities than time or money to pursue them. So they must choose – and just like your soccer/volleyball decision, those choices can be hard.
The best choices are made from among good alternatives. That’s because you tend to pay more attention to how much you’ll gain from each option… to think things through better. And because at least one of those options is more likely to end up being good.
The bigger a commitment is, the more you should consider opportunity cost. Are you deciding for a whole sports season or just for a week? Is your business thinking about investing $500,000 in new machinery or just fifty bucks?
Opportunity cost is actually a pretty big deal. What else could you do with your money? What else could you do with your time? What else could you do with your team, or with assets your business has like machinery?
There’s a whole world of opportunity cost out there. And often, in making decisions, opportunity cost and cash cost can get jumbled together.
Say the volleyball program is free, but the soccer one costs $100. The best thing to do is to first decide based on just the opportunity cost (which sport you really want to play more), ignoring the cash. If your opportunity cost of volleyball is higher than your opportunity cost of soccer, you should play soccer, right? Then factor in the cash: is it $100 higher?
Only you can decide…