As a business owner, you make several decisions at every level. Whether to take up a new project or not. Whether to hire an employee or outsource? Whether to buy equipment or rent it? Whether to invest cash or hold it? When you choose one option, the opportunity from the other option is lost. You might say, why remorse over something that you can’t get? However, in business, one always wants to maximize limited resources. The money spent buying equipment can no longer be used for something else. However, knowing the opportunity cost of the decision can help you weigh your options and make better decisions in the future. This opportunity cost won’t appear in your financial statements and will likely be an estimate. But you always want to know your options. Hence, it is beneficial to assess the opportunity cost to have confidence in your decisions.
Calculating Opportunity Cost
The formula for calculating opportunity cost is straightforward.
Opportunity cost = Cost of one option A – Cost of option B
While calculating the opportunity cost, try using actual data from industry standards (for salaries), competitor financials, and market interest rates (for loans). This could help you improve the quality and accuracy of your opportunity cost.
The Role of Opportunity Cost in Decision-Making
Suppose you have $15,000 in cash reserve. You decide to buy machinery worth $10,000 over the anticipation that you will get more orders. If the machine is used even at 80% capacity, it could make you $11,000 by saving the rental cost and producing more products. You also have the option to invest the money in stocks, wherein you expect to earn a $15,000 profit during the same period. However, the option of stock carries twice the risk as equipment.
By choosing equipment, you forego the opportunity to earn $4,000 extra. Here, you must analyze if this opportunity cost is worth the risk. If not, then you are better off with the first option. You could also look for ways to enhance the returns on the equipment by renting it out during off days or working towards getting more orders to use it in total capacity and increase profit to $15,000.
It all depends on how you use the opportunity and reduce the gap. The whole concept of opportunity cost revolves around which option gives you a comparative advantage.
Let us discuss a few use cases where opportunity cost can bring significant advantages.
Using Opportunity Cost in Workforce Planning
A small business has limited resources. Suppose you have two accounting consultants earning you a profit of $1,000 a day after deducting the cost (salary). You want to pursue an acquisition and need someone to do due diligence. This acquisition may not be a foolproof decision.
Should you shift these accountants to pursue due diligence or outsource the work to merger & acquisition consultants? When you talk to M&A consultants, you will get an idea of their charges. You can compare that with the cost of your accounting consultants and make a decision backed by information.
Small businesses outsource accounting, payroll, and bookkeeping because they find it more cost-effective than hiring a full-time employee. They weigh the opportunity cost and choose the option that is comparatively better for them. Given the volume of the work, some companies might opt for an in-house accountant.
The opportunity cost differs for different people and could vary for the same business in various scenarios. Let’s take an example.
Using Opportunity Cost in Determining Capital Structure
A company’s capital structure depends on how much money it raises from debt, equity, and retained earnings. Suppose a company has $50,000 in cash reserve and is considering holding cash, paying down debt, or investing in the business.
In a high interest rate environment with business uncertainty, a company might use its cash reserve to pay down debt as it sees a better opportunity cost coming from the interest expense savings. The same company might consider a loan to buy equipment in a low-interest-rate environment and substantial order volumes. Many companies hold higher cash reserves during a recession to keep their business operations running.
All these decisions are made after weighing the opportunity cost at that point. The opportunity cost approach can be used to make investment, estate planning, and employment decisions.
Contact McCay Duff LLP in Ottawa to Help You Make Informed Business Decisions
Business consultants can help you calculate opportunity costs and weigh the available options. They are skilled in forecasting and calculations and can provide detailed data analysis of the options to help you make informed business decisions based on facts. To learn more about how McCay Duff LLP can provide you with the best business consulting expertise, contact us online or by telephone at 613-236-2367 or toll-free at 1-800-267-6551.
