What Is Opportunity Cost?
Opportunity Cost is the value of one choice over another. Put simply, in economics Opportunity Cost refers to the Return on Investment (ROI) you receive through choosing one option over the alternative. This is an important factor in project management, resource allocation, and strategy generation.
Even though there is no set formula for calculating Opportunity Cost there are many different ways of thinking about it. For example, you could choose to work a full-time job earning $400 a day and running a dropshipping business worth $100 a day, over just a full-time job of $400 a day. The Opportunity Cost is $500 / $400 = $1.25. As a ratio, it is $1.25:$1. This figure means that for every $1.25 you make working and dropshipping, you would make $1 if you only worked full-time.
Why Is Opportunity Cost Important?
Opportunity cost is hugely important in decision making. Without it, we could not rationally make a business decision that makes economic sense to our businesses. This Opportunity Cost could simply be weighing up the advantages and disadvantages of choosing one pricing structure over another. It could also involve more complex thinking to achieve clarity on a subject. What is clear is the importance of Opportunity Cost to businesses.
For example, the Opportunity Cost of changing supplier could mean an increase in per unit cost but higher quality products. In the short term, you are investing more money than before so you consider increasing the price of the product for the customer. But in the longer term, these high-quality products can lead to happy customers. Customers will, in return, promote your products to friends if you keep the price steady, leading to strong market share. Therefore you need to choose whether to increase the product price. A business needs to make decisions like this every day and weigh up the pros and cons in order to remain profitable.
Opportunity Cost vs Trade-Off
Opportunity Cost and trade-offs are two tightly connected terms in economics. A trade-off is the choice you did not choose within your Opportunity Cost conundrum. Say you needed to choose between running a marketing campaign over hiring a salesperson. You project that hiring a salesperson would cost $3,000 a month and earn you $10,000 in sales, whereas running a marketing campaign would cost $1,000 a month and earn you $5,000 in sales. You calculate that the monthly sales revenue minus the cost of a salesperson is an Opportunity Cost of $7,000 in earnings whereas a monthly marketing campaign is $4,000. By choosing to hire a salesperson your Opportunity Cost is $1.75:$1 and your trade-off is a gain of $3,000 ($7,000 – $4,000 = $3,000).
Implicit and Explicit Opportunity Costs
Implicit costs are implied costs that are not captured through accountancy or other planning activities as a cost. This could include the cost of one employee to train another into a job, or the cost of machinery depreciating over time. Implicit costs are also known as Opportunity Costs in business terms.
Explicit costs are any costs involved in the payment of cash or another tangible resource by a business. This includes salary payments, new machinery, or renting office space, and are a mix of fixed and variable costs.
Opportunity Cost Example For Ecommerce Merchants
We have already given three examples of Opportunity Costs for ecommerce merchants. But there is an important Opportunity Cost specifically when choosing between a traditional ecommerce model and that of dropshipping.
With the traditional wholesale ecommerce model, a merchant decides on products to sell, and contacts suppliers to find the perfect fit for the company. Once suppliers are chosen the merchant orders a certain amount of units of each product from their suppliers. They then begin to sell these products to customers online through their website and other ecommerce portals like Amazon, etc. Once a sale is made the merchant ships the product to the customer.
The Dropshipping ecommerce model is different in one step. After a dropshipping merchant has found suppliers that are fit for purpose, instead of ordering quantities of products from the supplier, they place the products on their website. Only buy products from the supplier when orders come in from customers. The supplier then ships the product straight to the customer.
The Opportunity Cost arises here through the choice to buy products from the supplier before or after a customer buys from you. If you buy inventory before the sale, a merchant incurs the cost of the products until sold. They also need to incur the cost of storage and the cost of shipping to the customer. If units are not sold the merchant must then find a way to dispose of this excess product. What is clear from this model is that it is quite costly upfront. With dropshipping there is less cost upfront making the Opportunity Cost low.