What is opportunity cost?

Opportunity cost is the profit that was lost or missed because of some action or failure to take some action.

To illustrate opportunity cost, let's assume that you want to add a website to your already successful business. You are confident that it will increase your company's profit by $1,500 each week. A highly-trusted and successful firm will complete the website in 3 weeks with a total cost of $10,000. A friend has offered to do the work for $6,500 but it will take 5 weeks.

Choosing your friend looks better because the $3,500 saved ($6,500 instead of $10,00) is less than the opportunity cost of $3,000 (the $1,500 per week that is not earned multiplied times the additional 2 weeks it will take your friend to develop the website).

Now let's assume that your friend will require 7 weeks to complete the website. This means that your business will be losing the opportunity to earn an additional $1,500 per week for 4 weeks (your friend's 7 weeks instead of the firm's 3 weeks). That opportunity cost of $6,000 plus the $6,500 payment means a total cost of $12,500 if your friend develops the website. Hence, you would be better off paying the firm $10,000 and the benefit of having the site working 4 weeks sooner.

Interestingly, the opportunity costs are not recorded in the general ledger accounts. Hence, only the $6,500 paid to your friend will be recorded as the cost of the website. (The 4 weeks of missed profits are not recorded and will not be widely discussed.)

This is also a reminder that the opportunity costs and future amounts are the important ones for making decisions. Unfortunately, the future amounts are not in the general ledger and are probably not known at the time a decision has to be made.