What is opportunity cost?

Definition of Opportunity Cost

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

Example of Opportunity Costs

Assume that you want to add a website to your already successful business. You are confident that it will increase your company's contribution margin by $1,500 a week. A highly-trusted and successful firm will complete the website within 4 weeks at a set price of $10,000. A friend offered to develop your website for $6,500 but it will take 7 weeks.

Based on the out-of-pocket cost, your friend's bid looks better because of the $3,500 saved ($6,500 instead of $10,000). However, with your friend's work you will have lost the opportunity to earn an additional $4,500 (3 weeks at $1,500 a week). Therefore, the cost of you friend's work is $11,000 (the out-of-pocket cost of $6,500 + the opportunity cost of $4,500). The highly-trusted firm's cost of $10,000 now looks like the better option.

Interestingly, the opportunity costs are not found or recorded in the general ledger accounts. Hence, if you selected your friend's offer, only the $6,500 paid to your friend will be recorded as the cost of the website. (The 3 weeks of missed profits are not recorded and will not be widely discussed.)

This is also a reminder that the general ledger accounts are filled with past, historical amounts. Unfortunately, the relevant costs for decision making are the future costs and the opportunity costs (neither of which are not in the general ledger and are probably unknown at the time a decision must be made).