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What Is Opportunity Cost and How Does It Work in Business?

“Failing to plan is planning to fail” – Alan Lakein

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Opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another. While financial reports do not show opportunity cost, business owners can use them to make educated decisions when they have multiple options before them.

Because, (by definition) they are unseen, opportunity costs can be easily overlooked if one is not careful. Understanding the potential missed opportunities foregone by choosing one investment over another allows for better decision-making.

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How Does “Cost” Differ from “Opportunity Cost”?

Cost is usually taken to be amount or equivalent paid or charged for something, this can be monetary or resources. Opportunity cost is a loss of an opportunity: it is not a loss of something that you had but of something that you could have had; an opportunity you lose, not something you already have that you lose.

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How Does Opportunity Cost Relate to Economics?

Opportunity costs are fundamental costs in economics and are used in computing cost benefit analysis of a project. Such costs, however, are not recorded in the account books but are recognized in decision making by computing the cash outlays and their resulting profit or loss.

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What is a Low Opportunity Cost?

Opportunity costs may be somewhat high, indicating that it is necessary to forgo or give up a significant amount of resources in order to take advantage of a given opportunity. With low opportunity cost, the individual has to forgo or give up very little in the way of resources in order to take advantage of an opportunity.

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How do you Calculate the Opportunity Cost?

One formula to calculate opportunity costs could be the ratio of what you are sacrificing to what you are gaining. If we think about opportunity costs like this, then the formula is very straight forward.

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What is the Purpose of a Cost Benefit Analysis?

The cost/benefit analysis is a strategy or formula for evaluating the potential for some type of operation or project within the confines of a company or other organization. Essentially, the purpose of a cost benefit analysis is to ascertain if conducting the project or operation is feasible, given the current circumstances of the organization and the opportunity costs involved.

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Opportunity Cost vs. Sunk Cost

The difference between an opportunity cost and a sunk cost is the difference between money already spent and potential returns not earned on an investment because the capital was invested elsewhere, possibly causing financial distress. Buying 1,000 shares of company A at £1 a share, for instance, represents a sunk cost of £1,000. This is the amount of money paid out to make an investment, and getting that money back possibly requires liquidating stock at or above the purchase price.

From an accounting perspective, a sunk cost could also refer to the initial outlay to purchase an expensive piece of heavy equipment, which might be amortized over time, but which is sunk in the sense that you won’t be getting it back.

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Risk Management

By understanding and planning future costs and investments using the cost benefit business model and SWOT Analysis* (amongst other business analysis models), businesses can foresee risks, estimate impacts and define responses to an uncertain event or condition that, if it occurs, has a positive or negative effect on a project’s objectives.

The risk management plan contains an analysis of likely risks with both high and low impact, as well as mitigation strategies to help the project avoid being derailed should common problems arise.

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*SWOT analysis (or SWOT matrix) is a strategic planning technique used to help a person or organization identify strengths, weaknesses, opportunities, and threats related to business competition or project planning. It is designed for use in the preliminary stages of decision-making processes and can be used as a tool for evaluation of the strategic position of an organization.  It is intended to specify the objectives of the business venture or project and identify the internal and external factors that are favourable and unfavourable to achieving those objectives.