When it comes to business decisions, it is rarely the case that only one answer is available. Most decisions have options; many which affect the bottom line. If management is considering an expansion phase, does it make sense to simply add to the existing plant or to acquire an additional property? Should a new marketing channel be used to attract new customers? Using a benefit/cost ratio or net present value or other investment valuation model is helpful when examining mutually exclusive choices. However, those formulas determine a yes/no answer for each course of action when they’re looked at individually. Calculating the opportunity costs measures the direct impact that deciding against one course of action will have on the direction that is chosen by directors; knowing this impact can be beneficial when faced with two comparable choices.
The opportunity cost model (OCM) examines the marginal value between the options. The opportunity cost of capital is a commonly accepted component because it allows decision-makers to see the impact on the rate of return on invested capital that could have been used elsewhere. For example, does it make sense to acquire a competitor for $1 million or invest $1 million in another product line? The OCM reveals the potential income from not pursuing the additional product line combined with expenses, such as acquisition, operations, maintenance and so forth. By also adding the weight of capital costs, directors can not only understand what rewards can be reaped but also what the move will really cost over time.
There is no commonly accepted formula for deriving opportunity costs. The factors included will vary by industry and company. But the essential categories would be the financial gains and losses resulting from the declined option. An expanded version of the OCM will also include the cost of delay. Direct and indirect costs are typically included, as well as indirect value from the second course of action (e.g. goodwill). Relative pricing is recommended in order to calculate fair trade-off values for uneven price structures.
It is not always easy to attach values to nonmonetary impacts. Estimating environmental effects, for example, can be difficult to quantify and place a value on. Assumptions for values may vary depending on who is assigning the value. Finance experts agree that it is best to gather a range of estimates and determine the average cost of the effect from the course of action.
At the end of the day, examining the opportunity costs may uphold or reverse a decision to pursue an opportunity. It can explain whether the current course of business is the best choice. Excluding opportunity costs in financial analysis limits the scope of the impact a decision carries with it. Adding this type of examination to other valuation models can help ensure that moving in one direction won’t actually cost the company more than the discarded choice.
