How to Calculate Marginal Opportunity Cost

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Marginal opportunity cost is an important concept for any business owner to understand. Failing to take it into consideration before launching a business, investing in a business, increasing production or expanding into new markets could result in losing money when you thought you would be making money. While marginal opportunity cost is based on business costs, there are important distinctions between them. Increasing costs can often result in a decreased marginal cost, which usually corresponds to an increase in profit.

What Is Marginal Opportunity Cost?

Opportunity cost is something that affects everyone when they are faced with a buying decision. To illustrate this, suppose you're in a new restaurant looking at the lunch menu and you can't decide between the pasta, pizza and a sandwich. Those who find it hard to make decisions are painfully aware that ordering one item on the menu will immediately cost you the opportunity to order one of the others. The same principle applies to businesses. If you decided to open a hardware store and were selecting your location, signing a lease for one property would cost you the opportunity to choose a different location – at least for your first store.

Often, opportunity costs can be measured with money. If you decided to buy a sandwich for lunch and spent your last $10, and if you were on a limited budget, this could cost you the opportunity to buy a coffee later in the afternoon. The fewer resources you have, the higher the opportunity cost will be. Another way to measure opportunity costs is with time. If you only have a half-hour for your lunch break, you may be unable to order a second meal, even if you were hungry and had the extra money that day.

As you increase the number of purchases you make, the more each subsequent purchase will cost you in terms of opportunity. After having a sandwich in that new restaurant, for example, you always have the choice to go back for dinner to try the pasta. However, once you have finished your dinner and are full, it's unlikely you will have the opportunity to try the pizza that day.

Instead of saying the opportunity cost increases with each purchase, economists call this marginal opportunity cost.

Why Businesses Have Marginal Opportunity Costs

Just as consumers are limited in their resources, so too are businesses. There is an amusing anecdote that illustrates this very well: A billionaire who earns $100 million every year is walking down the street when he spots a dollar on the curb. It only takes him a second to pick it up, but the effort costs him two dollars – because he normally earns three dollars every second. If this anecdote was accurate, it would illustrate an opportunity cost of two dollars for the billionaire.

When a company produces something, the opportunity costs can be explicit or implicit.

Explicit Opportunity Costs

Explicit opportunity costs are any costs that could have been used for something else, like the cost of materials and labor to produce an item. If your company decides to purchase a delivery van, for example, the cost of fuel, insurance and the monthly payments will all have to come out of your budget, money which cannot then be used for other projects.

Implicit Opportunity Costs

Implicit opportunity costs include anything that you are unable to do because of the resources a project uses that don’t necessarily affect your profit. This is often a dilemma for sole proprietors when launching a new business. Suppose you have a day job and work on your new business at night. The opportunity cost could be your inability to earn overtime wages from your day job.

Most companies seek to make a profit. If a project does not make enough money and its opportunity costs are too high, this could force a company out of business; therefore, all opportunity costs, both explicit and implicit, should be considered before making a business decision.

As a sole proprietor running your own part-time business, suppose that you are earning on average 20 percent more than you would earn working overtime for your day-job employer. However, your employer then informs you that he will pay you double-time instead of time-and-a-half wages on weekends. This would then put your business at a loss, compared to what you could be earning with that pay raise. Obviously, for a budding entrepreneur, this wouldn’t necessarily be a reason to shut down a new business venture. However, you should still know what these costs are, particularly if you’re struggling to make your mortgage payments.

Accountants are generally only concerned with explicit costs, while economists consider both explicit and implicit costs. Consequently, accounting profits are almost always higher than economic profits.

The Opportunity Cost of Capital

If you are investing money in your business, the capital you invest also has an opportunity cost. For example, if you invested $500,000 in purchasing a new property for your company, you have lost the opportunity for investing that money somewhere else. You can calculate this cost by multiplying the interest rate or rate of return you would otherwise have received on the capital. If interest rates are 5 percent, then you have given up the opportunity to earn $25,000 with that $100,000 over the next year. In business, this is considered an explicit cost.

If you used someone else’s money, like that of a family member, then there is still an opportunity cost. But this would be an implicit, rather than explicit cost.

Additionally, the opportunity cost of capital is based on the value of the investment, not your cash outlay. If the property you purchased increased in value by the second year to $600,000, your opportunity cost would increase to $30,000, assuming interest rates remained the same. If the property depreciated in value, then your opportunity cost would also decrease. This is because you measure the opportunity cost by what you would get if you were to sell that property.

Determining Production Costs

So far, the examples we have used have been basic and easy to calculate. When calculating real business production costs, it is usually much more complicated. Production costs typically include fixed and variable costs. If you own a bakery, the cost of your building, property taxes, licenses and equipment would be fixed, while the cost of labor and energy to heat the ovens would be variable. Based on previous months, you can calculate the production costs to make a single loaf of bread by adding up all the costs for those months, divided by the number of loaves you produced.

If you decided to increase production, the fixed costs would remain the same, however, your variable costs – energy and labor – would increase, since you would be hiring more employees and keeping the oven on longer. If, however, you needed to buy an additional oven to increase production, you would have to factor this into your production costs as well.

While some variable expenses, like the cost of heating, may either increase or decrease with additional production on a per-unit basis. This would depend on how efficiently you could use the ovens. If you could bake two loaves in the same oven at about the same cost as baking one loaf, the cost would decrease with additional loaves. If you needed to turn on a second oven or keep the ovens running longer, this expense might be reduced for the extra loaves you bake.

Labor is another matter entirely. In many cases, additional labor becomes more expensive per unit as you increase production. This would be the case if you had to pay your bakers overtime wages, or if the extra bakers had to be trained, or were spending time waiting for others to finish using the equipment.

How to Calculate Marginal Opportunity Cost

To calculate the marginal cost of producing more items, divide the change in the total cost by the change in the quantity. Using the baker’s example, let’s assume that you currently produce 100 loaves every day at a unit cost of a 30-cents per loaf. To increase production by another 50 loaves, all costs remain the same per loaf, except labor, because you have to hire an additional person to work two hours at a cost of $10 per hour. Therefore, the marginal cost of producing an extra 50 loaves would be the increased cost ($20) divided by the number of additional loaves (50), which works out to be 40-cents per loaf.

Example: 150 loaves

MC = ΔTC/ΔQ

MC = $20/50

MC = $0.40

How to Decrease Opportunity Cost

Because opportunity costs are based on real costs, any time you are able to reduce your total costs, you will also be reducing your opportunity cost. However, this is not always the same as reducing your marginal opportunity cost. The marginal opportunity cost may go up instead.

Going back to the baker's example, suppose that for some bizarre reason you decided to bring in an additional employee for one hour to make only one extra loaf, rather than hiring her for two hours to bake 50 extra loaves. In that case, you divide the change in total cost ($10) by the change in the number of loaves (one), giving you a marginal opportunity cost of $10 for that extra loaf. This is obviously a much higher marginal opportunity cost than 50 loaves, which was only 40-cents per loaf for the 50th loaf.

Example: 150 loaves

MC = ΔTC/ΔQ

MC = $10/1

MC = $10

If you run the numbers through the same formula, you will find that producing the 149th loaf is slightly more expensive in its marginal opportunity cost than the 150th loaf. If you decided you wanted to produce 1,000 loaves of bread each day, requiring a larger facility, more staff and additional ovens, you may find that the marginal opportunity cost goes down, even though your total costs increase.

When it comes to production costs, decreasing the marginal opportunity cost is often a matter of producing more, rather than less product. This is because fixed costs can be divided into more and more units as your production increases. In many cases, even the cost of labor can mean a decreased marginal cost. In manufacturing, for example, the cost of setting up machinery and workspaces is the same regardless of how many units you are producing. If you were making video games, the cost of producing ten games may result in a much lower marginal opportunity cost than producing a single game, because many of the components of the programming can be reused for subsequent releases.

Looking at a case of capital investment, if you are able to use other people's money rather than your own, you will decrease your explicit opportunity costs. Although the implicit opportunity cost remains the same, the more money you get from other people, the more of your own capital will be free to use in other investments. While an economist may not applaud this distinction, your accountant and investment adviser most probably would.

References

About the Author

A published author, David Weedmark has advised businesses on technology, media and marketing for more than 20 years and used to teach computer science at Algonquin College. He is currently the owner of Mad Hat Labs, a web design and media consultancy business. David has written hundreds of articles for newspapers, magazines and websites including American Express, Samsung, Re/Max and the New York Times' About.com.