What is an opportunity cost?

Cost management plays a major part in your startup’s trajectory, especially at the pre-revenue stage when cash is tight and your R&D costs are quickly piling up. Understanding how to categorize your expenditures helps you efficiently allocate your resources and avoid common cognitive biases. A part of that means understanding which of your costs are considered opportunity costs.

Accurately identifying and handling opportunity costs helps your team make decisions based on potential future returns rather than past expenditures, optimizing growth and profitability.

Opportunity costs explained

Simply put, an opportunity cost is the lost benefit/gain from choosing one option over another (i.e. the cost of not doing something).

Let’s take an ecommerce startup that’s chosen to invest in a new marketing campaign rather than upgrade its website. If the business chooses to allocate $50,000 to marketing, the opportunity cost is the potential increase in sales that could have been achieved by improving the website’s conversion rate instead. This decision requires weighing which option might lead to greater long-term profitability and customer satisfaction. Understanding opportunity costs helps companies to optimize their resource allocation by choosing options that offer the greatest returns.

Types of opportunity costs

Categorizing opportunity costs by type helps to quantify their impact in monetary terms:

• Financial opportunity cost: This is the most direct form, where choosing one financial investment over another results in missed potential earnings from the alternative. For example, investing capital in stock A instead of stock B, where stock B ends up generating higher returns.
• Time opportunity cost: Time spent on one activity cannot be spent on another. For instance, a founder attending a conference may miss the opportunity to personally oversee a major project launch, potentially affecting its success.
• Labor opportunity cost: When a company allocates staff to one project, the labor is not available for potentially more valuable tasks. For example, using a development team to fix minor bugs instead of developing new features that could convert more customers.
• Resource opportunity cost: This occurs when physical resources are used for one purpose and therefore are not available for another, potentially more valuable use. An eCommerce business using warehouse space to store slow-selling inventory may miss out on storing higher-demand products.
• Educational opportunity cost: Choosing to pursue a degree in one field means forgoing the potential benefits of studying in another potentially more lucrative or fulfilling field.
• Social opportunity cost: In personal and professional settings, spending time in one social engagement might mean missing out on networking opportunities or personal relationships that could have offered different benefits.

How to calculate opportunity costs

Systematically assessing your startup's opportunity costs enables better decision-making, potentially extending your runway. Typically, the option with the highest net benefit, after considering opportunity costs, is the optimal choice.

1. Identify alternatives: Start by listing all potential alternatives for the resource being allocated, whether it's time, money, or other assets. For example, if you're considering investing in new equipment, potential alternatives might include investing in marketing, R&D, or expanding your workforce.
2. Estimate the returns: For each alternative, estimate the expected return or benefit. This process may involve financial projections, market research, historical data, or consulting with an objective 3rd party. For financial investments, this could mean calculating the expected rate of return. For time or labor, consider the potential revenue or value added if it were to be used on an alternative project.
3. Compare the best alternative: Select the alternative with the highest return—that constitutes your opportunity cost. This is the best-forgone option against which you should compare your original option. If possible, quantify the opportunity cost in monetary terms. For instance, if the alternative investment has an expected return of 10% on $100,000 over the next year, your opportunity cost for not choosing this investment is $10,000.
4. Consider non-financial factors: Sometimes, opportunity costs include non-financial factors like customer satisfaction, employee morale, or long-term strategic positioning. These should also be considered, though they might not be as easily quantifiable.

Common mistakes when handling opportunity costs

Avoiding common pitfalls requires a disciplined decision-making approach that includes thorough analysis, continuous reassessment, and balanced consideration of both short-term and long-term outcomes:

1. Ignoring indirect costs: Often, decision-makers focus solely on direct costs and ignore indirect costs like maintenance, training, or long-term support. This can skew the true cost of an option.
2. Overvaluing immediate benefits / undervaluing future benefits: There's a tendency to favor options that offer immediate returns, potentially overlooking alternatives that, although slower to realize, may offer greater overall value. Decisions can be shortsighted when future benefits are discounted too heavily compared to more immediate, but less significant, gains.
3. Relying on intuition or incomplete information: Decisions made without thorough analysis or based solely on gut feelings can lead to overlooking critical data that would influence a more informed choice.
4. Failure to reevaluate: Not regularly reviewing decisions when new information arises can result in persisting with ineffective strategies.
5. Bias in decision-making: Cognitive biases, such as confirmation bias or status quo bias, can lead decision-makers to favor information that supports their preconceptions or to resist changing existing plans, even when it's beneficial.
6. Underestimating external factors: Failing to account for economic shifts, regulatory changes, or market dynamics can lead to misjudging the true opportunity cost, as these factors can drastically alter the landscape in which a decision unfolds.

Coming to grips with opportunity costs is crucial for startups, particularly during the early stages of development and scaling. By accurately identifying and calculating these costs, startups can make more informed decisions, ensuring that every resource allocated maximizes its potential returns. This longitudinal approach helps safeguard against common pitfalls like the misjudgment of indirect costs and underestimation of long-term benefits, thereby maximizing growth in competitive environments.