Opportunity Cost

What is Opportunity Cost and how to calculate it for your Project

Think of all the decisions that get made every day in daily life.  There are a lot right?  Consider also the likelihood that for every decision made there are several options that were discarded or traded-off to achieve the outcome.  

In daily life we might have processes to qualify our decision making such as talking things through with someone we trust however on occasion there are decisions that we simply can’t make without clearer information on what that decision will really cost us.  This is usually because we have a limit on or scarcity of the available resources which can only be spent in one place.  

Opportunity cost example

An example of opportunity cost in everyday life might be in your weekly budget:

I have only 50 dollars available for the work week and need my two coffees per day which are $5 each.  I would also like to be able to buy lunch some days but can only afford it if I opt to use my scarce funds differently.  

The simple formula for this definition of opportunity cost is ‘Opportunity Cost = What One Sacrifices / What One Gains’.  

In this example the opportunity cost of buying lunch is two of my coffees in the week or conversely each coffee purchased is 0.5 lunches.  This opportunity cost or trade-off can be visualised on a graph such as the one below.  

What I can see from my analysis is the trade off I will make for every decision to buy lunch this week and the opportunity lost as a result of that decision.

Opportunity Cost in Project Management

So how do I translate this to Project Management?  The first and simplest application is when making decisions on use of resources for one task or activity versus another.  Like our example of the coffee vs. lunch trade-off, project decision making is most important at portfolio level when assessing the different projects I can invest in with my limited budget or it can also be applied within a project where I have finite or fixed resources to draw on.  This level of assessment does not change the investment amount but the prioritisation of allocation based on a clear business case.

For many basic portfolios, opportunity cost may be very high level and based on inputs such as the risk, impact or consequence of not doing a project. For example a compliance project will be prioritised over a system enhancement project given the consequent is different.  

In more advanced portfolios, the opportunity cost can be measured based on the different financial returns or monetary value a project can generate for the company.  

In many cases the metric that can be used for Opportunity cost assessment is Net Present Value or NPV.  This makes the opportunity cost of not doing a project equal to the NPV of that project.  This process can help rank projects and make it easier for a management decision to not proceed with a project with a low NPV.  While this is a relatively straight forward approach, be careful that NPV is not your only portfolio metric given the consequence of not doing a low NPV project (again, the example of a compliance project) could be high.

Opportunity cost is a simple way to manage your portfolio (or how many coffees you have) and can really streamline portfolio management.  If you decide to use it as part of your processes such as reviewing new projects requests, start with the metrics that are most suited to your organisation and the projects you manage.  This will ensure you can quantify the benefits that will not be realised (financial or non-financial) and in turn the opportunity lost of a decision.

In our Project Management Glossary video series, you can find a simple detailed explanation of Opportunity Cost: both term definition and examples 👇

Opportunity cost FAQs