If you’re 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). The PMBOK should be your primary resource when studying for the exam as it is the globally recognized standard and guide for the project management profession. However as you probably already know, it doesn’t cover every possible topic that the PMP test may touch on.
One of those topics not covered is the concept of “opportunity cost.” There’s no guarantee that you’ll see it during your exam, but there’s also no guarantee that you won’t see it. In this article I explain why as a project manager you need to understand opportunity cost and what it is. I also go through a couple of examples of opportunity cost questions.
Why You Need to Understand Opportunity Cost
It’s possible as a project manager that you’ll be charged with project selection at some point in your career. You’ll need to make sure you evaluate and select projects based on your organization’s goals and needs to ensure returns are maximized and that opportunity costs are minimized. As part of the project selection process, you’ll need to evaluate where to best utilize 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 organization only has so many resources and needs to take on projects with the highest potential for success and the greatest return.
Opportunity Cost Explained
A simple explanation for opportunity cost is this: the loss of potential future return from the second best unselected project. In other words, it’s the opportunity (potential return) that won’t be realized 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 and both require the same set of resources, then selecting Project X for completion over Project Y will result in an opportunity cost of $20,000. You can’t do Project Y, so you lose $20,000 in choosing Project X — the “loss” of not completing Project Y.
Let’s take a look at a couple of sample PMP exam-style questions around opportunity cost to help you understand it better.
Question 1: Which definition best fits “opportunity cost”?
a) The sum of all of the potential returns of projects not selected.
b) The potential return of the second best project that was not selected.
c) The difference between the potential return of the project selected and the potential return of the second best option that was not selected.
d) 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’s also not the difference between the present value of cash inflows and the present value of cash outflows; that’s the definition of net present value (NPV).
Question 2: You are part of a project selection team…
…The team is evaluating three proposed projects and you need to select the project that would bring the best return for the organization. Project A has an NPV of $25,000 and an internal rate of return (IRR) of 1.5; Project B has an 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?
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 question is simply asking for 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. But even so, it’s still an important concept 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. And they always are.