2017-03-01 00:00:00Decision MakingEnglishUnderstand opportunity cost, learn how to quantify it using net present value, and incorporate it into decision-making.https://quickbooks.intuit.com/ca/resources/ca_qrc/uploads/2017/06/Realtor-writes-down-opportunity-costs-on-notepad-at-office-table-next-to-brochures.jpghttps://quickbooks.intuit.com/ca/resources/decision-making/incorporating-opportunity-cost/Incorporating Opportunity Cost into Decision-Making

Incorporating Opportunity Cost into Decision-Making

2 min read

At some point, you may need to decide whether to add new services or try to bring in more clients with existing services. Whichever route choose, you expect the benefit of increased sales. However, if you have to choose between those two business plans due to resource constraints, you get the benefit from pursuing one business plan while forgoing the benefit from the other. Such decision-making between two opposing business opportunities incorporates the evaluation of opportunity cost, which often uses net present value, a proxy of the potential benefits from two opposing choices.

Understanding Opportunity Cost

The opportunity cost is really the benefits that you lose by choosing to do one thing instead of the other. The key point behind opportunity cost is that two mutually exclusive courses of actions may not provide the same level of benefit, leading to the need to make a decision. To further complicate the matter, you can only estimate the future benefit each option may produce. You choose what you think is the best option at the time and risk not actually getting the best result from the chosen course of action. In other words, if the option you didn’t choose actually produces more benefit than the option you did choose, you incur the opportunity cost, equal to the benefit differential between the return of the more lucrative non-chosen option and the return of the less beneficial that you’ve chosen. For a better chance of choosing the option with the higher return, make decisions by incorporating the opportunity cost and evaluating potential outcomes based on net present value.

Evaluating Opportunity Cost

The decision-making process can cost money in itself – that is, you direct resources at it when investigating two potential course of actions. You may spend more money evaluating one option and less on the other. Such expenditures are called sunk costs, the money that is spent and gone, and you should not incorporate them into the decision-making. The option receiving more investigating dollars may have a lower estimated return. You shouldn’t go with an option just because the resource devoted to it is too much to ignore. You should base your decision on the net benefit that a chosen option can provide. The net benefit that a future course of action may produce can be best expressed in net present value. Net present value is the sum of an investment’s expected cash inflows from future years valued in today’s money and then deducted by initial investment outlay. For example, you could invest a certain amount of money to get new services up and running, or you could market your existing services to more clients. If your analysis indicates that additional marketing of existing services has a higher net present value than plotting out new but untested services, you choose to market your existing services as a way of expanding your business. If the proposed new services later actually catch on with customers and generate more net sales, you lose the extra benefit and incur an opportunity cost. Choosing between offering new services and marketing existing services is a matter of evaluating the opportunity cost and using net present value for benefit comparison. Once you make your decision, it should incur as little opportunity cost as possible.

References & Resources

Information may be abridged and therefore incomplete. This document/information does not constitute, and should not be considered a substitute for, legal or financial advice. Each financial situation is different, the advice provided is intended to be general. Please contact your financial or legal advisors for information specific to your situation.

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