Opportunity costs are associated with almost any decision we make in life. Choosing between going to college or business school, deciding which job offer to accept, etc. In startups, the opportunity cost can be anything from time, money, or resources. How can a good understanding of opportunity costs help improve your startup’s decision-making?
What are the opportunity costs in a startup?
Opportunity cost is a term used to describe the cost of an opportunity that is given up in order to take a different course of action. It is an important concept in business and economics, as it is applicable to many different situations. The term is most often used in reference to investments, but it can also apply to other decisions as well.
In other words, it’s what you give up when you choose one thing instead of another. A simple example would be deciding between two investments: A and B. If you invest in A, you will make $100 a year for 10 years, but if you invest in B, your return will be $200 a year for 10 years. The opportunity cost for investing in B is $100 per year ($200 – $100).
An entrepreneur’s opportunity cost is the amount of money they could have made if they had made the decision to invest their time and money in a different venture. It’s an important concept to understand because it helps entrepreneurs to determine which projects are worth pursuing.
The three main kinds of opportunity cost
- Financial opportunities cost. How much money you would have made if you had taken a different decision with your investment strategy.
- Organizational opportunities. How much time and resources were wasted on making the wrong decision.
- Personal opportunities cost. How much stress or frustration you went through because of the wrong decision.
The three key components of opportunity cost
- Opportunity cost. The value that you give up by not doing something else. In other words, the benefit you would have gotten if you had chosen something else instead.
- Opportunity gain. The benefit that you get by doing something instead of not doing it. In other words, the benefits you receive in return for your decision.
- Opportunity cost value. The sum total value gained or lost by all possible options.
Opportunity costs vs. sunk costs
In order to make the best decisions for your startup, you must be aware of the difference between opportunity costs and sunk costs. The opportunity cost is what you lose by not investing in a certain venture. The sunk cost is what you have already invested in it.
Opportunity cost is the cost that a person or company loses when they choose one option over another. It’s about what you give up, not what you gain. In other words, it’s all about what you don’t do. Opportunity costs can be either monetary or non-monetary.
Sunk costs are costs that have already been incurred and cannot be recovered while opportunity costs are the potential benefits that could be gained if the sunk cost was not made. The key difference between these two costs is that the opportunity cost will only affect your decision if you have time to recoup your investment. The sunk costs are permanent and can’t be recovered.
How to calculate the opportunity cost of a decision
The formula for calculating an opportunity cost is simply the difference between the expected returns of each option.
Opportunity Cost = Value of Next Best Alternative - Value of Decision
For example, if you were offered a job that pays $50,000/year. The opportunity cost of accepting the job would be the next best alternative to this decision would be staying at your current job that pays $40,000/year. To put it simply, the opportunity cost is ($50,000 – $40,000) = $10,000.
Deciding between multiple opportunities
The decision-making process becomes harder when you have more than one opportunity. It can be overwhelming to make a decision because there are so many factors to consider. The factor that is often overlooked in the decision-making process is the opportunity cost. What will you give up in order to take something else?
When it comes to making a decision between multiple opportunities, it is important that you take your time and weigh out the pros and cons of each opportunity. While there are some things that cannot be quantified, like personal values and emotions, there are others that can be quantified such as monetary value.
We’ve put together five tips for better decision-making using opportunity costs:
- Make sure that you have a clear understanding of what your goal is and what you’re trying to achieve. This will help you to know which decisions are more important and which ones can be put on hold until later.
- If you have multiple options available, don’t make your decision based on one factor alone. Instead, consider all factors and make sure that they’re in line with your goal.
- Consider all possible outcomes when making a decision. You should also consider how each outcome will affect other areas of your life (i.e., personal well-being, career, relationships, etc).
- Use a decision tree, which uses a series of questions and decisions to help map out your options and their consequences.
- Keep track of what you’re learning by writing down what insights you received as a result of your decisions. Try to make use of these insights in future decisions to help you achieve your goal.
Without the right decision-making skills, startups cannot grow their business and reach their goals.
The idea of a venture is to become an entrepreneur and take a risk in order to reap success. Some entrepreneurs are more interested in the potential for success than the risk involved in the venture.
The risks that come with a venture are many. But they can be managed if the entrepreneur is prepared: the threat of failure or not reaching your goals can be mitigated by planning ahead or learning from other people’s mistakes.
It is often difficult to identify and avoid opportunity costs as they happen, but it is possible to mitigate them by being aware of them and prioritizing your time accordingly. Calculating your startup’s opportunity cost will help you identify what your most valuable resource is and how to use it most effectively.