What is Opportunity Cost and Why Do You Need to Understand It

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cornelius.fichtner
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If you are in the middle of preparing to take the Project Management Professional (PMP) Exam you have undoubtedly read through A Guide to the Project Management Body of Knowledge (PMBOK Guide) – Fifth Edition at least once and possibly even more. If you are just starting to prepare to take the PMP Exam, then you should be planning to read through the PMBOK Guide at least a couple of times. The PMBOK Guide should be your primary resource when studying for the PMP Exam as it is the globally recognised standard and guide for the project management profession; however as you probably already know, it does not cover every possible topic that the PMP Exam may touch on.

One of those topics not covered by the PMBOK Guide is Opportunity Cost. There is no guarantee that you will see it during your PMP Exam, but there is also no guarantee that you will not. Here we will explain why as a project manager you need to understand Opportunity Cost, beyond that it may be on the PMP Exam, and what exactly Opportunity Cost is. We will also go through a couple of examples of Opportunity Cost questions.

Why does a Project Manager need to understand Opportunity Cost? It is very possible as a Project Manager you will be charged with project selection at some point in your career. You will need to make sure you evaluate and select projects based on your organisation’s goals and needs to ensure returns are maximised as well as opportunity costs are minimised. As part of the project selection process you will need to evaluate where to best utilise valuable resources such as specific skill sets, time, and of course money. Allocating these resources to a specific project prevents their use for other projects at the same time, after all an organisation only has so many resources and needs to take on projects with the highest potential for success and the greatest return.

What is Opportunity Cost? Opportunity cost is the loss of potential future return from the second best unselected project. In other words, it is the opportunity (potential return) that will not be realised when one project is selected over another. For example, if Project X has a potential return of $25,000 and Project Y has a potential return of $20,000, then selecting Project X for completion over Project Y will result in an opportunity cost of $20,000. That is the “loss” of not completing Project Y.

Let’s take a look at a couple of PMP Exam sample questions around Opportunity Cost:

PMP Exam Sample Question 1: "Which definition best fits Opportunity Cost?"
  1. The sum of all of the potential returns of projects not selected.
  2. The potential return of the second best project that was not selected.
  3. The difference between the potential return of the project selected and the potential return of the second best option that was not selected.
  4. The difference between the present value of cash inflows and the present value of cash outflows.
The correct answer is B. Opportunity Cost is the potential return of the second best option that was not selected. It is not the sum of all potential returns that were selected or the difference between the potential return of the project selected and the second best option. It is also not the difference between the present value of cash inflows and the present value of cash outflows as that is the definition of net present value.

PMP Exam Sample Question 2: "You are part of a project selection team evaluating three proposed projects and you need to select the project that would bring the best return for the organisation. Project A has an NPV of $25,000 and an IRR of 1.5, Project B has a NPV of $30,000 and an IRR of 1.25, and Project C has an NPV of $15,000 and an IRR of 1.5. What would be the opportunity cost of selecting Project B over Project A?"
  1. $15,000
  2. $5,000
  3. $25,000
  4. $30,000
The correct answer is C. Opportunity Cost is the potential return of the project not selected. In this case we did not select Project A, so it is $25,000. There is extra unrelated information in this question; IRR is not relevant when evaluating opportunity cost. Once all of the unnecessary information is filtered out the questions is simply asking what is the dollar value associated with Project A.

Opportunity Cost simply comes down to the benefits or returns that are passed up when one project is selected over another. Understanding what Opportunity Cost is may or may not be necessary when taking the PMP Exam. Even if questions about Opportunity Cost are not on your PMP Exam it is still important for you as a Project Manager to understand Opportunity Cost as it is a method for selecting one project over another especially when valuable resources are limited.

About the author: Cornelius Fichtner, PMP is a noted PMP expert. He has helped over 34,000 students prepare for the PMP Exam with The Project Management PrepCast at http://www.pm-prepcast.com and The PMP Exam Simulator at http://www.pm-exam-simulator.com
Until Next Time,
Cornelius Fichtner, PMP
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