According to Investopedia, opportunity costs are
“… the benefits an individual, investor or business misses out on when choosing one alternative over another.”
The first question will be: why not taking both options. Well, there are limits. Whether it is money, time, space or something else, but we are limited to one option only. So, we make a choice and decide which option to go with. And unless this option is in all aspects better than the second-best, there are some sacrifices or costs we have to bear due to our choice. And this is the opportunity cost.
Here we have to mention that we are comparing only the choice we have made with the best-known alternative. Apple or ice cream after dinner? The opportunity cost may be cold compared to increased immunity if we go for the alternative (apple). Opting for an extended warranty for a device. The opportunity cost is the extra money we pay, which will be wasted unless something happens to the device. Don’t take this as advice against extended warranty, though.
On the below links you can find more definitions and explanations of the term opportunity cost
It is essential to define what are the opportunity costs of business decisions. This helps to decide between alternatives. In simple words, what will we not get if we choose this option? If we analyze the pros and cons of two best options, basically the pros will be what we are losing if we decide not to go ahead with this option.
Here we have to discuss two possible versions of opportunity cost.
Explicit cost can be directly measured in money. So, if we take a longer route to work to pick up a team member, we can exactly calculate how much us this cost. Or if we give a discount to our customer in order not to lose a contract.
Implicit cost cannot be measured in money. If we make saving on our customer service team, the reputation of our company gets damaged. While the ultimate result will be monetary, we can not establish a direct correlation.
Now, why is this so important in business, and especially in Procurement and Supply Chain?
It may happen that we, focusing narrowly only on the benefits of the given project. Sometimes we overlook damage or missed opportunity in the wider scope (the business as a whole). When we compare two vendors, we should not only focus on choosing the best. There is a need to see if the second-best offers something that can significantly impact the project as a whole.
Let me illustrate this with an example. A company is building its new headquarters. And they have picked light fixtures that were very beautiful, and as well with a very good price. But only a single supplier is providing those fixtures. And the second-best option is available in multiple locations. So now whenever they have a broken fixture, they need either to wait a couple of months or pay expensive airfreight for their fixture. By paying a bit more at the start they could avoid this cost.
Some well-known project analysis models do not consider Opportunity costs. For example, the Cost-benefit analysis focuses only on the benefits of a project. It does not consider the potential opportunity costs of taking an alternative option.
So, next time when you have to choose between two options, discuss the Opportunity costs as well. You may be surprised by the outcome