What Is Opportunity Cost?

Opportunity cost refers to the potential gains that an individual, investor, or corporation forego while choosing one alternative over another. Because opportunity costs are, by definition, invisible, they are frequently neglected. Understanding the possible missed possibilities when a company or individual chooses one investment over another enables more informed decisions.

Opportunity Cost Formula and Calculation

Opportunity Cost=FO−CO, where:

FO=Return on best forgone option

CO=Return on chosen option

The difference between the projected returns of each option is the formula for computing an opportunity cost. Consider the following two mutually incompatible possibilities for a company:

Option A: Invest any excess funds in the stock market in order to potentially achieve financial gains.
Option B: Reinvest extra funds in the business to purchase new equipment to improve production efficiency.

Assume the stock market’s estimated return on investment (ROI) is 12% over the next year, and your company expects the equipment update to create a 10% return over the same time period. The opportunity cost of investing in equipment rather than stocks is 2% (12%–10%). In other words, by investing in the company, the company foregoes the possibility of earning a larger return.

While financial reports do not include opportunity costs, business owners frequently use the notion to make informed judgments when faced with several options. Bottlenecks, for example, frequently result in opportunity costs.

The Difference Between Opportunity Cost and Sunk Cost

A sunk cost is money that has already been spent. However, an opportunity cost is a potential return on an investment that will not be earned in the future because the capital was invested elsewhere. When calculating opportunity cost, any previously spent sunk costs are omitted unless there are particular variable outcomes associated with those monies.

Purchasing 1,000 shares of business A at $10 per share, for example, implies a $10,000 sunk cost. This is the amount of money paid out to invest, and recovering it requires selling stock. Instead, the opportunity cost asks where that $10,000 could have been better spent.

A sunk cost can also refer to the initial outlay to purchase a costly piece of heavy equipment, which may be amortized over time but is sunk in the sense that you will not be getting it back.

Example

Consider the foregone gains generated elsewhere when purchasing a piece of heavy equipment with an expected ROI of 5% vs. one with an expected ROI of 4%. Again, an opportunity cost describes the profits that could have been obtained if the money had been invested in another instrument instead. Thus, while 1,000 shares of company A may eventually sell for $12 per share, resulting in a $2,000 profit, the value of company B climbed from $10 to $15 within the same time period.

In this case, investing $10,000 in firm A yielded a $2,000 return. On the other hand, investing the same amount in company B yielded a $5,000 return. The $3,000 difference is the opportunity cost of selecting Company A over Company B.

As an investor who has previously invested, you may come across another investment that promises higher returns. The opportunity cost of holding the underperforming asset may escalate to the point where selling and investing in the more promising investment is the reasonable investment alternative.

Risk and Opportunity Cost

Risk in economics refers to the chance that the actual and predicted returns on an investment differ and that the investor loses some or all of the principal. Opportunity cost is the risk that the returns on a chosen investment will be lower than the returns on a forgone investment.

The important distinction is that risk compares an investment’s actual performance to its anticipated performance. On the other hand, opportunity cost compares an investment’s actual performance to the actual performance of another investment.

Still, while choosing between two risk profiles, one should consider opportunity costs. If investment A is risky but has a 25% ROI, while investment B is significantly less risky but only has a 5% ROI, investment A may or may not succeed. If it fails, the opportunity cost of choosing option B will be obvious. Consequently, when comparing options, decision-makers rely on far more information than simply looking at cash figures for opportunity costs.

Accounting Profit and Economic Profit

Different sorts of firm profits are calculated using opportunity cost. Accounting profit is the most typical sort of profit analysts are familiar with. Accounting profit is a type of net income calculation that is sometimes required by Generally Accepted Accounting Principles (GAAP). Only explicitly stated, real costs are deducted from overall revenue.

Companies or analysts can manipulate accounting profit in the future to achieve economic profit. The distinction between the two is that economic profit includes opportunity cost as an expense. This theoretical computation can then be used to compare the company’s real profit against the theoretical profit.

Economic profit (and any other calculation that takes opportunity cost into account) is solely an internal value utilized for strategic decision-making. There are no governing authorities that govern the public disclosure of economic profit or opportunity cost. Accounting rules and guidelines have a big impact on profit, but management’s vague assumptions and guesses have a bigger impact on economic profit, which is not regulated by the IRS, SEC, or FASB.

Opportunity Cost Examples

Opportunity cost can be utilized to make decisions for both firms and individuals in a variety of situations. Decisions might sometimes entail intangible rewards or factors. However, when someone makes a financial decision, opportunity cost can often assist in finding the optimal option.

Here are some examples of how to calculate opportunity cost when weighing two alternatives:

Example #1

Here’s an example of a company that wishes to expand its operations by opening a new location:

Fran’s Fountain Pens wishes to expand and open a new site because business is booming. The rent for a storefront on Main Street is $3,000 per month. Rent for a storefront on Maple Street is $2,500 per month. According to their calculations, they would attract the same amount of consumers in either location. Thus, renting on Main Street represents a $500 opportunity cost.

Fran’s Fountain Pens chose a storefront on Maple Street to save money in this case. If one of the storefront locations had seen significantly more foot traffic, it might have made more sense to choose that location in the aim of increasing sales volume.

Example #2

Here is someone estimating the opportunity cost of two different degrees:

Ray is debating whether he should study architecture or business. He can attend the same school for both programs, which means that his tuition and living expenses will be the same. He wishes to obtain a bachelor’s degree in his chosen field of study in order to keep the overall cost of his education constant. Ray calculates the opportunity cost by determining his predicted earnings in both sectors. He discovers that a bachelor’s degree in business earns a salary of $50,000. In comparison, a bachelor’s degree in architecture offers an annual salary of $55,000.

This indicates that if Ray studies business, he will incur a $5,000 annual opportunity cost for the remainder of his working life. If Ray’s only consideration is money, he will almost certainly pursue architecture. Ray also explains his satisfaction. Ray decides if he would enjoy a profession with a business degree to the same amount that he would enjoy a career as an architect at a $5,000 per year opportunity cost.

Example #3

An example of someone estimating the opportunity cost of various savings and investment alternatives is shown below:

Sam’s grandma gives her $1,000 as a birthday present when she turns 21. She now earns enough money to cover her living needs, so she plans to invest the money from her grandma. Sam decides to put the money in a high-yield savings account or a certificate of deposit (CD) with her local bank after reviewing her alternatives. The yearly interest rate on the high-yield savings account is 5%, while the CD is 7%. Sam can compute her opportunity cost in percentages or dollars to determine which option is best for her.

Her opportunity cost is $20 ($1,070 – $1,050) or 2% per year (7% – 5%) if she invests in the high-yield savings account. In this situation, Sam should put her money in the CD if she is confident she can lock it away for a year without needing to access it. If she puts her money in a CD and then wants to access it before the end of the year, she will face an early withdrawal penalty, which might wipe out the benefits of choosing the CD over the savings account.

Example #4

Here’s an example of a company that wants to launch a new product but wants to know the opportunity cost of doing so:

Molly’s Mattresses would want to launch a new range of mattress toppers. Its factory is currently at capacity, hence the company has determined that it has to expand or open a second factory. They predict that establishing a new factory will cost $45,000, and expanding their current factory will cost $20,000.

If the company extends its current plant, it will miss two weeks of output, costing approximately $17,000. If it extends its manufacturing, the total cost will be $37,000. The opportunity cost of constructing a new plant in this case is $8,000 ($45,000–$37,000). Molly’s Mattresses saves money by expanding its factory rather than building a new one, even with the cost of closing production for two weeks.

What Is A Simple Definition Of Opportunity Cost?

In essence, opportunity cost refers to the hidden cost of not pursuing a different path of action. If, for example, a corporation pursues a specific business plan without first assessing the merits of alternative strategies available to them, they may overlook their opportunity costs and the chance that they could have done even better had they taken a different path.

Is There Such a Thing As Opportunity Cost?

Opportunity cost is not directly reflected in a company’s financial statements. Economically, though, opportunity costs remain quite substantial. However, because opportunity cost is a very abstract term, many businesses, executives, and investors fail to account for it in their day-to-day decisions.

What Does Opportunity Cost Look Like?

Consider an individual who, at the age of 18, was pushed by their parents to invest 100% of their discretionary income in bonds. This investor invested $5,000 every year in bonds for the next 50 years, earning an average annual return of 2.50% and retiring with a portfolio worth over $500,000. Although this result appears to be excellent, it is less so when the investor’s opportunity cost is included. If, instead, they had put half of their money in the stock market and earned a 5% average blended return, their retirement account would have been worth more than $1 million.

How Do You Calculate Opportunity Cost?

The disadvantage of opportunity cost is that it is strongly dependent on estimations and assumptions. There’s no way of knowing how an alternative course of action would have affected the bottom line. As a result, in order to calculate the opportunity cost, a business or investor must estimate the outcome and forecast the financial impact. Sales volumes, market penetration, consumer demographics, production costs, customer refunds, and seasonality are all factors to consider.

This complex circumstance explains why opportunity costs occur. A company’s optimal course of action may not be obvious at first; but, after retrospectively examining the variables listed above, they may better see how one choice would have been better than the other and they have experienced a “loss” owing to opportunity cost.

In Conclusion,

The idea behind opportunity cost is that your resources as a business owner are constantly restricted. That is, because you have limited time, money, and experience, you cannot take advantage of every opportunity that arises. If you choose one, you must necessarily abandon the others. They are not compatible. Your opportunity cost is the worth of those people.

Finally, opportunity cost is about the decisions you make rather than about money or resources. It’s important to remember that one action or choice can prevent you from taking benefit of other choices.

What Is Opportunity Cost?

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