In this article, we will take a detailed look at opportunity costs long with some of the ways for managing them. We will also take a look at a few sample questions based on this topic for better PMP exam prep.
What is an opportunity cost?
Opportunity Cost is a key concept in Economics that expresses the basic relationship between scarcity and choice.
Scarcity results when natural resources, human resources and capital resources are not available in sufficient quantity to satisfy requirements. So, a producer has to decide what he wants to produce from a particular resource. For instance, if he chooses to produce paper for books from a stand of trees, then no other product can be produced from that stand of trees. Yet, there are many products that could have been produced using the same natural resources, which are also desired by consumers.
The opportunity cost of the decision thus becomes an important consideration. While making a choice the producer needs to realize that the next best alternative cannot be produced.
In Decision Making, therefore, opportunity costs are usually the difference between the net value of the path that was chosen and the net value of the best alternative that was not chosen. This concept is also relevant to the profession of Project Management where, opportunity costs are usually the cost of the opportunities we missed by investing our money on a particular project. It is based on the theory that a dollar can only be invested at one place at a time. It is one of the project selection methods that organizations use, to select projects which are feasible and desirable. For project selection purposes, the smaller the opportunity costs are, the better as it is not desirable to miss out on a greater opportunity.
How do we manage our opportunity costs?
By considering opportunity costs, we can make adjustments to reduce costs or reduce overall future effort. Considering opportunity costs does not by itself reduce or change costs; it makes those costs explicit so that we can consider them and manage them appropriately.
Considering opportunity costs improves transparency and makes effective decision making easier.
If an organization has an investment in dollars that is made available to projects, then it is quite important to decide which projects should get what amount. This decision is usually made on the basis of benefit returns to the company.
Usually, benefit returns are risky because they are earned in the future. Therefore, benefit returns must be adjusted for risks before they are incorporated into the formula. The opportunity cost is then the difference in returns, after risk adjustment, between one project opportunity and the next most favorable opportunity that is competing for the same capital.
The role of a project manager, in this context, is to provide risk management so that the returns are maximized to the extent possible; and manage capital budgets to minimize capital expenditures. Those two activities will maximize the returns and minimize the opportunity cost of the project.
Sample Questions for the PMP certification Exam
We may find a few questions in the PMP certification exam which is based on the concept of opportunity cost. For the exam opportunity cost is usually a monetary value. Let us take a look at a few sample questions based on this concept.
Sample Question 1
You work in the PMO of a mid-sized company. Your PPM tool shows that there are currently 3 new projects waiting for selection. They are Project Diamond with an NPV of Rs.15,00,000, Project Gold with an NPV of Rs 17,00,000 and Project Silver with an NPV of Rs.13,00,000. You present these 3 projects at the monthly project selection board meeting. After initial discussion it was immediately decided that Project Silver will not be pursued at all. At this point a lengthy discussion begins about the benefits of both Project Diamond and Project Gold. After about an hour, the CEO asks you: “What is the opportunity cost of selecting Project Diamond instead of Project Gold?” What should be your answer?
Answer: Although the question is presented to us as a complex problem, it is quite simple to answer the question .The opportunity cost when selecting between two projects is simply the value of the project that is not selected. Project Gold has an NPV of Rs.17,00,000. If this project is not done, then the lost opportunity is Rs.17,00,000.
It is also important to note that Project Silver was never a part of the equation.The CEO only wanted to know the opportunity cost when selecting between the other two projects (i.e Project Diamond & Project Gold).
Sample Question 2
Project Apple has an IRR of 19% and an NPV of $26,000 for 3 year duration. Project Banana has an IRR of 24% and an NPV of $28,000 for 5 year duration. What is the opportunity cost, if you select project Apple instead of project Banana?
Answer: When selecting between two projects, the opportunity cost is simply the value of the project that was not selected. In this case, we selected project Apple over project Banana. This means that our opportunity cost = the value of project Banana = $28,000. The IRR and duration of the projects are irrelevant here.
Opportunity cost is the difference between the net value of the path that was chosen and the net value of the best alternative that was not chosen. It is a great tool for project selection in many organizations. Risk management and capital budget management are some of the ways in which a project manager can minimize the opportunity costs and maximize the returns in his projects. We may find a few questions based on this concept in the PMP certification exam.
Learn about Opportunity Costs and how to manage it and improve your PMP Certification Exam Prep. Get sample PMP Exam Questions for practice based on Opportunity Costs.