Why it's good to keep track of opportunity cost as an entrepreneur

Opportunity cost is a term often used in economics. But what does it really mean? And why is it good to know about it when running a business?

‍

‍

As an entrepreneur, you are faced with various choices and priorities on a daily basis, big and small, and for every choice you make, something else has to take a back seat. It doesn't have to be that you actively choose one of several options, but your resources are not infinite. Therefore, every resource used in a certain way means that the same resource cannot be used in another way. And this is where opportunity cost comes in. This is because opportunity cost describes the lost revenue, or value, of the alternative that was chosen.

‍

There is therefore much to gain from learning about opportunity cost. Because taking it into account in decision-making will lead you to make more informed decisions that benefit your business the most. When you invest time, money or other resources in one part of your business, you indirectly opt out of other potential investments. Considering what is being sacrificed will allow you to make more informed decisions that maximize the use of resources and have the greatest impact for the company both in the long and short term.

‍

‍

Using opportunity cost in decision making

Once you understand what opportunity cost means, you should take it into account when making decisions about your business. Consider all the options before making your decisions and understand what you will give up if you choose each option. By doing so, you can better analyze the different options, estimate the value of your resources and prioritize the one with the highest return.

‍

When it comes to different investments, opportunity cost can come into play in different ways depending on whether it is a question of an either-or decision or whether it is about how to allocate a resource. Let's say, for example, you are going to buy a machine and you are choosing between two options. Option 1 is cheaper, but option 2 has a higher capacity and can therefore produce more. In simple terms, the opportunity cost if you choose option 1 is the loss in production that option 2 would have given, which would then have led to you being able to sell more. If you had chosen option 2 instead, it would have meant that you had to spend more money initially and thus prioritize something else. The opportunity cost of option 2 would then have been what you could have used the difference for if you had chosen option 1 instead. So here it becomes a trade-off to see which choice would have given the greatest return seen as a whole.

‍

Opportunity cost thinking can also help you prioritize and value your time better as an entrepreneur. A clear example is the question of managing finances yourself or hiring someone. Hiring someone costs money, but doing it yourself means you need to spend time on it. You then need to sacrifice time that you could have spent on things that generate revenue. You can either save time or money and the trade-off is whether or not the revenue you would have generated in the time you saved would exceed the cost of getting help. A further example is whether to prioritize between different ventures and problems. You may have four different things you are able to accomplish in a given period of time. Three of them require less resource use while one requires more, and you need to choose between doing either the three smaller ones or the larger one. In this situation, it is easy to tackle the smaller tasks as they are likely to have a shorter start-up time and it feels good to get things done. But if all three smaller efforts together have less effect than one larger one, it is a waste of resources to prioritize them instead of the larger one.

‍

‍

Opportunity cost and financing

Have you ever considered whether you should save up for an investment or take out a business loan and make the investment here and now? Or have you thought about whether to increase your purchases but are afraid of putting too much strain on your cash flow? In both cases, the opportunity cost would help you make the most optimal decision. If you save up for an investment instead of using finance, you certainly save on the cost of interest. But if you had made the investment using finance, you would have received a return on it sooner. If you save up for it, the opportunity cost will therefore be the forgone return until you make the investment. If the opportunity cost is higher than the interest cost of the business loan, your business would have benefited from using finance. The question of financing major purchases works in a similar way. If the potential profit you can generate from making larger purchases, i.e. the opportunity cost of not doing so, is higher than the cost of the financing, then making larger purchases using financing is optimal.

‍

‍

The long-term effect

Using opportunity cost allows you to make more informed decisions that maximize your company's resources and generate the highest possible returns. As a result, you'll be better able to identify potentially profitable opportunities, navigate change, and not cling to sub-optimal strategies. Overall, you will become better at planning for the future, setting realistic goals and developing strategies that leverage your company's strengths and capitalize on market opportunities. This will lead to you being more successful in your business.