Opportunity cost

What it means

Opportunity cost is the benefit of the best alternative a company gives up when it chooses another option. If a company uses its own building, it forgoes the rent it could earn from it. If cash is tied up in stock, it forgoes the return that money would bring elsewhere.

It does not appear in the books because it is not an actual expense. For decisions, however, it is essential. A project’s economic profit is what remains after deducting not just the accounting costs but also what the company would have earned from the best alternative.

The concept is related to the cost of capital and the discount rate in NPV, which also express the return investors could earn elsewhere. The opposite is sunk costs, which can no longer be changed and have no place in the decision.

How it works in practice

When deciding on an investment, a lease or expanding production, we help clients compare not only the accounting profit but also the alternatives. A project that looks profitable in management accounting may be worse than simply paying off an expensive loan.

A typical example in small companies is the owner’s time. If the director spends dozens of hours a month on administration that an outside partner could do more cheaply, they are sacrificing time they could devote to sales and customers.

In pricing and job costing, opportunity cost shows up at full capacity. If a company accepts a cheap job, it may miss a better one it no longer has room for. The price should reflect what is given up for the capacity.

What to watch out for

A common mistake is treating own resources as “free”. Equity, a building or the owner’s time have value even though nobody sends an invoice for them. Decisions that ignore them systematically understate real costs.

The second risk is the opposite extreme: endlessly searching for a better alternative and never deciding. Opportunity cost should help compare real options, not paralyse decision-making.