Opportunity costs are a key input factor in making business decisions
Opportunity costs can be seen as the price paid for making a certain business decision
Opportunity costs are an economic concept to quantify benefits of alternatives that were ignored while making a decision. Precisely, opportunity costs are the value of the best alternative that was not chosen. For example: in a case interview, as a part of a business solution for a food supermarket, you recommend to use a share of the space for pre-prepared food items instead of a small restaurant (best alternative). Here, opportunity costs would be the revenues that would have been made by utilizing the space for the small restaurant instead of pre-prepared food items. Make sure to mention this in the interview and calculate the lost revenues in opportunity costs if necessary.
Opportunity costs are required to determine the attractiveness of various options
Most options will be mutually exclusive (see MECE). Thus, deciding on one option usually means forgoing an alternative. Note that the the basic principle is always to go for the option with the highest opportunity costs since this option would be the most expensive if it is ignored. In the previous example of a small restaurant vs. pre-prepared food, we assumed the opportunity costs of pre-prepared food to be higher than of a small restaurant. Since the option with the highest opportunity costs is chosen, the net effect on business is still beneficial (expected revenues from pre-prepared food items MINUS expected revenues from small restaurant).
Opportunity costs are closely related to discounting, which is a standard procedure utilized in finance. The discounting rate depicts the opportunity costs of investing the money for a certain interest rate somewhere else. Think about why we choose a discount rate of 5%. This is because we could opt for another investment (same risk-return ratio) that yields 5% as an alternative.
Consider opportunity costs for every decision made
Remember, every action or inaction is a decision at the end of the day. Opportunity costs occur whenever you make a decision. Keep in mind that all your actions, including the trivial “not doing anything”, lead to costs since you forgo benefits of alternative decisions. Therefore, always make your entire option space transparent and rate your options based on opportunity costs because doing so will help you make the right decision. Through the calculation of opportunity costs you are able to conduct a valid like-for-like benchmarking and pick the best option.
In a case interview, you will need to use the concept of opportunity costs in cases that involve Valuation or M&A situations since in these cases you often need to determine client's willingness to pay for certain companies. The willingness to pay is mainly determined by the options you have and the associated opportunity costs.
Below are two business case examples on how you can incorporate opportunity costs in the decision-making process
Business case: investment
- Assume you have $100,000 and you are offered an investment which has a return of 10% after one year. This means you will earn $10,000 in year 1. You need to decide against this investment. What are the opportunity costs of this decision?
- Now, you need to evaluate the next best option. If you leave the money at home, you don’t earn anything and after a year, you still have $100,000 instead of $110,000. Thus, the opportunity costs of your decision are $10,000. But if you deposit the money in a bank and earn 2% interest, you actually would have $102,000 in your account after a year and opportunity costs in this case would be $8,000 ($ 10000 - $ 2000).
- See this example from another perspective in discounting.
Business case: production
- Assume your client produces fabrics. A square meter of fabric costs $8 in production and it can be sold for $10 at a profit of $2. The client decides to build another factory which produces clothes. Instead of selling the fabric on the market, the client passes it on to the new factory. Total costs of production for clothes (which need 1 square meter) are $13 ($8 + $5) and they sell them for $16 with a profit of $3. What are the opportunity costs of this idea?
- Since the client has foregone his profit from selling the fabric, his opportunity costs are $2. In this case however, the new idea seems to be the better one as the client generates higher profits. Opportunity costs are still important, for example if you want to define the value and profitability of the idea: Opening a new factory will generate $1 ($3 - $2) after taking opportunity costs into consideration.