In microeconomics, the theory of opportunity cost is a forward-looking concept of the economic value of the next best (or sometimes better) alternative that is foregone when another alternative is chosen. This economic cost is explicit and implicit and hence different to the accounting cost which is just the explicit cost to the organisation. Simply, it is the value sacrificed by the decision made at the time of the decision and beyond. In personal terms, if I buy a more expensive house, I may sacrifice the ability to buy an expensive car. I make the decision intuitively, but in business, intuition is an inadequate justification.
This concept is used in corporate finance when appraising different investment opportunities and is easily overlooked as these are unseen costs that investment proposers may not highlight. By factoring in these opportunity costs, decision-makers can make better decisions as they have a clearer picture of the missed opportunities they are forgoing.
Let’s take a look at an example for the social housing sector. A housing association has a group of void assets that, when let, will generate £50,000 per year of revenue. The options are to:
Make no further investments in the group of assets and they will continue to generate £50,000 per year in real terms.
Invest £350,000 and then generate £100,000 per year of revenue through remodelling.
Over 10 years, the opportunity cost of choosing option 1 over option 2 is £50,000 and will increase for each year after as shown below.
The gain over the opportunity cost is not great (at £50,000) but when the net present value of these costs (their value in today’s money at the outset) is factored in, the gain is much smaller and possibly not worthwhile. Understanding the opportunity cost of investments is key to making informed decisions and therefore should always be evaluated. Without doing so, opportunities can be missed and poor investment decisions can be made which may not stand up to scrutiny.
Is opportunity cost a real cost?
This is not well understood amongst some individuals as it is an “economic” cost, not an accounting cost and therefore is an “abstract” concept which does not show up on financial statements. However, ignoring it in the short term can have a substantial effect on the future performance of organisations and investors, as it is lost profits, so should not be ignored lightly.
Why consider Opportunity Cost?
Making investment decisions without evaluating their opportunity cost leads to suboptimal decision making. Calculating the NPV of investment options (alongside other financial and strategic yield and risk factors) and then evaluating the opportunity cost of those investments is an evidence-based approach to decision making, rather than leaving it solely to intuition or precedent, which are poor substitutes and can lead to costly mistakes in the long run.