Opportunity Cost
New entrepreneur experiences challenge when selecting where to invest the finance in obtaining high returns on investment. The concept of the opportunity cost applies when the investor has several options and wishes to settle on a particular alternative. “Therefore, the opportunity cost is the value of the foregone alternative” (Read, Olivola & Hardisty 2016, p. 8).
The concept is applicable in economics and finance theories, especially when making correct investment decisions. Its primary function is to be a measurement of economic decisions taken in relation tother best alternatives. For instance, opportunity cost exists in financing a debt company over stock issuing (Read et al. 2016). Opportunity cost is a critical feature that significantly impacts peoples’ lives. For example, it affects choices made on money, lifestyle, family, home, and career.
Opportunity cost is broadly applicable in the career path where the individual has to choose either going to school or becoming an entrepreneur. After joining the learning institution, the student has many specialisation options which the best alternatives can be selected by applying the concept of the opportunity cost. In the business field, the entrepreneur has to decide whether to settle on local or international business deals. Issues of personal savings also apply the idea of opportunity cost. People have a decision to consider either to save in preparation of retirement from the age of 30 or 45 in a bid to receive many benefits in future (Read et al. 2016).
According to Read et al. (2016), the opportunity cost is significant as it influences the future state of nature or lifestyle of a person (p. 10). In the case of Bill Gates, he chooses to deal with software development rather than getting employed by IBM firm. The decision to become a software developer instead of a company’s employee made him prosper in the business field (Read et al. 2016).
Opportunity cost has been broadly classified into two by economists (Explicit and Implicit). The common feature in the two is that they embrace opportunity cost from a positive view – the choices made are in full knowledge of their consequences to the real World. However, they slightly differ as explained:
Consider a situation where a company invests $4,000 in lawn mowers. The opportunity costs which is explicit in the scenario is for any other operation in the company which could have utilized the $4,000. In this case, the forgone costs include the advertisement fee, website upgrading charge and value of acquiring a new computer to the company which also become the explicit opportunity cost (Read et al. 2016).
Implicit cost is, however, a bit different since it does not have a direct accounted value. For example, the $4,000 is used for lawn movers instead of upgrading of the company’s website. In a small business scenario, the owner may decide to forgo his/her salary to be used in integral functions to achieve success (Read et al. 2016). The value of the salary which is not paid is defined as the implicit opportunity cost. When the owner sacrifices his/her salary the business is relieved the pressure of financing some activities.
The simple formula of arriving at the opportunity cost is illustrated as follows:
Opportunity Cost (OP= Value of items Sacrificed/Value of what is gained ((Read et al. 2016). The principal aim of the equation is to relate what one obtains as a result of leaving the other.
Opportunity cost can be narrowed down to three significant components such as time, money, and effort. Time sometimes is considered more critical and priceless in relation to money. Every business decision must always factor in the interest of time. Many corporations and small business must always ask the question of what other things the cash can be used for before arriving at the expenditure decisions. The company which decided to spend the $4,000 on lawn mowers instead of website upgrade considered it as a final decision though the money could not be retrieved back. Therefore, the website upgrade was the opportunity cost (Read et al. 2016). A person may decide to start a small business instead of a big company to reduce the much energy needed in corporations. The extra effort required in case of a company becomes the opportunity cost.
The term “risk” is closely related to opportunity cost but not the same. A risk is the probability of unfavorable occurrence after making a certain business decisions while opportunity cost is the positive impact that could have been experienced from an alternative utilization of the same commodity.
Reference
Read, D., Olivola, C. Y., & Hardisty, D. J. (2016). The value of nothing: Asymmetric attention to opportunity costs drives intertemporal decision making. Management Science, 63(12), 4-42.