What to know about Opportunity Cost for the PMP Exam?
This post talks about the concept of “opportunity cost”. Every PMP® aspirant would wonder why they will need to learn about concepts and knowledge not covered in the PMBOK® Guide. This is a actually the top common misconception about the exam! In fact, the PMP® Exam is not just about the PMBOK® Guide. The syllabus of the exam is outlined in the PMP® Examination Content Outline which include areas much wider than the PMBOK® Guide.
No, Opportunity Cost is NOT in PMBOK® Guide
If you are preparing for the exam, there is a high chance that you have already read the PMBOK® Guide which is often considered the “textbook” for the exam. However, the PMBOK® Guide does not include everything that would be tested on the exam, and “Opportunity Cost” is one of such topics that exam takers have encountered in the real exam.
Though, opportunity cost is just one of these topics and you will mostly likely to have only 1 or even 0 questions in your exam, it is indeed an important concept in the real world project management world to help you select the best course of actions to achieve the best value return. Therefore, every project manager is highly recommended to understand the concept and how to apply opportunity cost in project management scenarios.
It is quite possible that, in the role of project manager, you will be charged with the task of project selection in your career. You will need to evaluate and select projects based on the organization’s goals and needs to ensure maximum returns with minimal opportunity costs, i.e. how to best utilize resources such as specific skill sets, time and money.
Below, we will try to explain briefly what exactly Opportunity Cost is and go through a couple of sample questions to help Aspirants to know how to answer opportunity cost questions.
What is Opportunity Cost?
Opportunity cost is the loss of potential future return from the best alternative project when a choice is required for several mutually exclusive projects.
It can also be defined as “the opportunity (potential return) that will NOT be realized for the second best project not selected”. Since there are limited resources such as human, time, money, etc., we cannot work on infinite number of projects at the same time. Opportunity cost is a concept to help you judge which project(s) to take and which project(s) NOT to take based on the relative potential returns of the project(s).
- Project A has a potential return of $25,000
- Project B has a potential return of $20,000
- Project C has a potential return of $10,000
The opportunity cost for selecting Project A for completion over Project B and C will be $20,000 (the “potential loss” of not completing the second best project).
By considering opportunity cost while making a selection from several promising project, the limited resources can be allowed to be utilized in the most efficient manner.
However, we should not limit ourselves by just considering the projects as mutually exclusive (the most important factor in opportunity cost) at a pre-mature stage, we should try to explore creative ways which would allow the different goals and values to be realized with the limited resources or how different projects can create synergy instead of treating the different project separately.
But for the PMP® Exam, the situation is often simplified enough to allow simple comparison of the potential returns of the projects.
Mock Questions on Opportunity Cost
Let’s take a look at a couple of sample questions on the topic of Opportunity Cost below:
Sample Question 1: “Which definition best fits Opportunity Cost?”
- The sum of all of the potential returns of projects not selected.
- The potential return of the second best project that was not selected.
- The difference between the potential return of the project selected and the potential return of the second best option that was not selected.
- The difference between the present value of cash inflows and the present value of cash outflows.
The correct answer is B.
Explanation: 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.
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 organization. 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?”
The correct answer is C.
Explanation: 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. Note that there is always extra unrelated information in PMP® Exam questions – IRR is not relevant when evaluating opportunity cost. Aspirants need to filter out all the unnecessary information in the questions in order to find the correct answers for the questions.
~ Written by Cornelius Fichtner, PMP®, CSM – Instructor and producer of PM PrepCast™ and Edward Chung, PMP®