How opportunity costs can affect your cash flow

Deciding where to invest, whether that’s buying new equipment, creating a new product or hiring new staff, is something business owners frequently grapple with. It’s rare that any business has the luxury of doing everything at once.

Though opportunity costs are a prediction, and therefore never certain, they can help you decide where to invest and therefore have an impact on your business’ cash flow management.

What is an ‘opportunity cost’?

An opportunity cost represents the potential benefits you may miss out on when choosing one investment over another. Each option you consider will have an associated cost and set of potential benefits. As such, no matter what you choose, there will be a cost and some benefits forgone – this is the opportunity cost.

How to calculate an ‘opportunity cost’

To find the opportunity cost you’ll need to work out the return you expect to make from the investment and weigh this against the other option.

To do this effectively, you should consider that some options will take longer to return their investment but may have scope for higher growth.

Simply put, calculating an opportunity cost is simply finding the difference between the returns, or expected returns, of each option. This can be done when choosing between two options or with hindsight after the investment has been made. After calculating how much each investment has or is predicted to return, you can use this formula:

Opportunity Cost = Benefit of Chosen Investment – Benefit of Forgone Investment

An opportunity cost example for small businesses

A simple opportunity cost scenario is deciding where to locate your business. Say you have two office spaces you’re considering. Option A is £5,000 a month in a central desirable location, option B is in a less desirable suburban location but is £3,000 a month for the same amount of space.

Option B would leave you £2,000 better off per month, significantly improving your cash flow and leaving cash to invest elsewhere. However, you may decide against this cash flow-friendly option if the centrally located office presents longer-term opportunities, such as ease of networking or attracting a wider range of talent for job roles. In this scenario, you’d need to decide which opportunity is right for your business and your cash flow needs, and which opportunity cost you’re happy to forgo.

Some other common examples of opportunity costs:

When a business decides to produce one product over another, the opportunity cost is how much they could have made on the other product versus the one they decided to make.

If a company decides to take out a loan and spends £10,000 on the loan’s interest, the opportunity cost is the parts of the business the £10,000 could’ve been spent on like marketing, hiring new staff or product development.

When deciding to take a lump sum and put it into one stock investment instead of another, the opportunity cost is the difference in the return on investment.

What is the impact of opportunity cost on cash flow?

Because opportunity costs involve deciding where to invest in your business and how much you’re predicted to make back, it can have significant implications on your business’s cash flow.

You may ask yourself questions such as: how quickly do I need a return on my investment? Does my cash flow have more flexibility to allow for a slower rate of return but with scope for higher returns?

Figuring out how the opportunity costs interact with your business’s financial health is key to understanding the answers to these questions.

Though opportunity costs aren’t certainties, they can be a useful tool to help business owners make smarter decisions. It’s worth remembering that they’re heavily based on assumptions so should be understood as part of a bigger picture when looking at the health of your business.

How can small businesses manage their cash flow with opportunity costs in mind?

Before weighing opportunity costs, it's vital to understand your business’s cash flow. You can get to grips with cash flow forecasting for small businesses with Xero’s free cash flow forecast template and check out the cash flow resource hub for more ideas and support.

Keep track of your business finances with Xero’s accounting software for small businesses.