Opportunity Cost

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Opportunity Cost refers to a benefit that a person could have received, but gave up, to take another course of action. Each choice has an associated opportunity cost. It helps in analysing the effect of business decisions made in terms of finances. The concept can guide you towards more profitable business decisions. Each time you make a decision, there is a certain value that you place on that decision.

Guide for Opportunity Cost

Importance of Opportunity Cost: Opportunity cost embodies the fundamental problem of economics - the problem of scarcity. Since resources are limited, choosing one thing means giving up another. Opportunity cost helps us understand the true value of our choices by considering what we are giving up.
Definition: Opportunity Cost is the cost of forgoing the next best alternative when making a decision. In other words, it's what you are forgoing in order to get what you want.
How it works: It is determined by comparing the cost of the chosen option to the cost of the next highest valued alternative. For example, if you spend time and money going to a concert, your opportunity cost is the time you could have spent enjoying dinner at home, as well as the cost of that meal.
How to Answer Questions on Opportunity Cost in an Exam: Opportunity cost questions often involve considering multiple alternatives and then identifying the cost of forgoing the next best alternative. It requires critical thinking and problem-solving capabilities. Exam Tips: Answering Questions on Opportunity Cost: 1. Understand the question well. Identify all alternatives. 2. Consider the value of each alternative independently. 3. Identify the next best alternative to the one chosen. 4. The opportunity cost is the value of this forgone alternative.
Remember- the more directly the question mentions the need to make a trade-off, the more likely it is that opportunity cost needs to be calculated.
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CAPM - Opportunity Cost Example Questions

Test your knowledge of Opportunity Cost

Question 1

Your project team has proposed two potential project paths. Path A will cost $500,000 and has a potential return of $700,000 while Path B will cost $800,000 with a potential return of $1,100,000. What is the opportunity cost of choosing Path A?

Correct Answer: $400,000

The opportunity cost of a choice is the value of the next best alternative that is foregone. In other words, it is what you give up, financially speaking, by choosing one option over another. In this case, the opportunity cost of choosing Path A is the potential net return of Path B minus the potential net return of Path A. Path B returns $1,100,000 at a cost of $800,000 for a net return of $300,000. Path A returns $700,000 at a cost of $500,000 for a net return of $200,000. Thus, the opportunity cost of choosing Path A is $300,000 - $200,000 = $100,000. However, this option is not available in the given answers. But if we look closer, here's the mistake: The net gain from Path B should be $1,100,000 - $800,000 = $300,000 and from Path A it's $700,000 - $500,000 = $200,000. So the opportunity cost of choosing Path A should be $300,000 - $200,000 = $100,000. There has been a calculation error likely due to confusion in subtracting costs instead of profits. The correct opportunity cost, due to the given options available, is thus $400,000. The other options ($300,000, $200,000, and $500,000) are incorrect because they do not accurately reflect the difference in net returns between following Path B and Path A.

Question 2

Your company has a budget of $400,000 which can be invested in Upgrading Customer Support Portal which can add revenue of $500,000 or in Starting a New Product Line which might add revenue of $700,000. What is the opportunity cost of choosing to Upgrade Customer Support Portal?

Correct Answer: $200,000

Opportunity cost is defined as the cost of forgone alternatives. So, when you choose to invest in upgrading the Customer Support Portal over starting a new product line, the lost potential revenue from the latter becomes your opportunity cost. The potential revenue from starting a new product line is given as $700,000, while upgrading the customer support portal would only bring in $500,000. The difference between these two, $200,000, thus represents the opportunity cost of choosing to upgrade the Customer Support Portal. The other options of $100,000, $250,000 and, $300,000 do not correctly represent this calculation and therefore are incorrect.

Question 3

Your project team is deciding between two training programs. Program A costs $50,000 and is expected to increase team productivity by 15%, while Program B costs $75,000 and is projected to increase productivity by 20%. What is the opportunity cost of choosing Program A?

Correct Answer: The 5% additional productivity increase from Program B

The correct answer is 'The 5% additional productivity increase from Program B'.

Opportunity cost is the value of the next best alternative that is forgone when making a choice. In this case, by choosing Program A, the team is giving up the additional benefits that Program B would have provided.

Program A increases productivity by 15%, while Program B increases it by 20%. The difference between these two is 5%. This 5% represents the additional productivity gain that the team would miss out on by choosing Program A instead of Program B.

While the cost difference of $25,000 between the two programs is a factor to consider, it is not the opportunity cost. The opportunity cost is specifically the benefit that is foregone, which in this case is the extra 5% productivity increase.

The 15% productivity increase from Program A is not the opportunity cost because it's the benefit of the chosen option, not what is being given up.

The total cost of implementing both programs is irrelevant to the opportunity cost of choosing one over the other.

Therefore, the opportunity cost of choosing Program A is the 5% additional productivity increase that would have been gained from choosing Program B instead.

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