What is the opportunity cost of a decision?

What Is Opportunity Cost?

Individuals, investors, or businesses lose out on potential gains when they choose one alternative over another.

By definition, opportunity costs are hidden, which makes them easy to overlook.

When a business or an individual chooses one investment over another, they may miss out on potential opportunities.

Key Takeaways

• If a choice is not made, an opportunity cost would be incurred.
• If opportunity costs are to be properly evaluated, all options available must be considered and weighed against one another.
• Taking opportunity costs into account can help individuals and organizations make more profitable decisions.

Formula and Calculation of Opportunity Cost

Formula and Calculation of Opportunity Cost

Opportunity Cost=FO−CO
where:
FO=Return on best forgone option
CO=Return on chosen option
​A measure of opportunity cost can be calculated by comparing the expected returns of the two options.

Consider option A, which is to invest in the stock market with the hope of generating capital gains.

As an alternative, you can reinvest your money back into the company in the hopes of increasing production efficiency, thus resulting in lower operational expenses and a higher profit.

Let’s say your company expects the equipment update to generate a 10% return over the next year, and the stock market will return 12%.(12% – 10%) = 2 percentage points if we choose the equipment over the stock market.

You would be sacrificing the opportunity to earn a higher return by investing in the business

Opportunity cost tells you what you need to know.

What Opportunity Cost Can Tell You

Analysis of opportunity costs is essential for determining a business’s capital structure.

When a company issues debt or equity, it incurs an expense to compensate lenders and shareholders for investment risks, yet both carry an opportunity cost.

The funds used to pay off loans, for example, are not permitted to be invested in stocks or bonds, which can provide investment income.

By leveraging the power of debt, the company can expand and generate more profits than it would have been able to make through investments.

To minimize opportunity costs, a firm evaluates both monetary and non-monetary factors before issuing debt or stock.

Due to opportunity cost being a forward-looking consideration, the actual rate of return for both options can’t be determined in practice until the future.

Let’s say the company in the example opts to invest in the stock market instead of buying new equipment.

Rather than enjoying the expected 12% return, the company might lose money if the selected securities decrease in value.

Consider 0% return on investment, meaning the company gets exactly what it puts in. Choosing this option will result in a 10% opportunity cost.

Even though the company chose new equipment, it is possible that profits would remain stable if there was no impact on production efficiency.

This option has an opportunity cost of 12% instead of the expected 2%. Comparing investment options with similar risks is important.

Treasury bills, which are virtually risk-free, can lead to incorrect calculations if compared to highly volatile stocks.

There is no guarantee that the stock market will return 5%, while the U.S.

Treasury guarantees the T-bill’s return, while there is no such guarantee for stocks.

When you consider the relative risk of each investment, despite the 0% opportunity cost of each, the T-bill is the safer choice.

Comparing investments

Businesses look for investments that are likely to yield the greatest return when assessing their potential profitability.

It can often be determined by examining an investment vehicle’s expected rate of return (RoR).

Businesses should also take opportunity cost into consideration, however.

For example, suppose a business must choose between investing $20,000 in securities or buying new machinery with that money.

No matter which option a company chooses, the opportunity cost is the potential profit the company gives up by not investing in the other.

According to the first option, at the end of the first year, the business’s investment will amount to $22,000.

(Current Value – Initial Value) / Current Value * 100 is the formula for calculating RoR.

Based on this example, the Return on Investment on the investment is 10%, since [($22,000 – $20,000) / $20,000] * 100 = 10%.

In this case, let’s assume that there would be a 10% gain every year following that.

The return on investment will be $10,000 in year 1, $12,000 in year 2, and $14,000 in year 3, assuming a 10% rate of return.

Alternatively, the business can increase its production of widgets by purchasing a new machine.

It will take time and effort to set up the new machine, and the machine will not be operating at full capacity for the first few years.

Taking the additional expenses for training into account, it would net the company an additional $500 in profits in the first year.

In year two and every subsequent year, the business will earn $2,000 and $5,000 respectively.

The company must choose between both options because it has limited resources.

Therefore, in the first and second years, choosing the securities is worth the opportunity cost.

The new machine proves to be the more affordable option after analyzing the opportunity cost ($500 + $2,000 + $5,000 – $2,000 – $2,200 – $2,420) = $880.

The Difference Between Opportunity Cost and Sunk Cost

The Difference Between Opportunity Cost and Sunk Cost

A sunk cost is what has already been spent, while an opportunity cost is what could have been earned through an investment but which has been invested elsewhere.

Sunk costs are costs that have already been incurred, such as buying 1,000 shares of company A at $10 a share.

An investor pays out money to invest, and in order to recover that money, the stock must be liquidated at or above the purchase price.

However, the opportunity cost instead asks whether the $10,000 could have been spent more wisely.

Sunk costs can also refer to the initial cost of a heavy piece of equipment, which is amortized over time but which is lost in the sense that it will not be recouped.

The opportunity cost can be calculated by comparing the return on investment (ROI) of a piece of heavy equipment with one with an ROI of 4% with one with an ROI of 5%.

In the same vein, opportunity costs describe how much one could earn if the money was invested in something else instead.

Therefore, while 1,000 shares of company A might eventually sell for $12 a share, netting a profit of $2,000, its value would have risen from $10 a share to $15 during the same period.

This means that investing $10,000 in company A would return $2,000, but investing the same amount in company B would return a larger amount of $5,000.

A difference of $3,000 represents the opportunity cost of choosing company A over company B.

Even if you have already invested money, you might come across another investment that promises higher returns.

Eventually, the rational investment option may be to sell the underperforming asset and invest in the more promising investment because of the opportunity cost of holding it.

Opportunity Cost and Risk

It refers to the possibility that the investor may lose some or all of the principal of an investment if the returns are different from those projected.

An opportunity cost is the possibility that a chosen investment will have a lower return than a forgone one.

Risk measures an investment’s actual performance against its projected performance, whereas opportunity cost measures an investment’s actual performance against its actual performance, and vice versa.

Nevertheless, opportunity costs should be considered when comparing two risk profiles.

Investment A may succeed despite the risk, but it may not if investment B, which is far less risky, has an ROI of only 5%.

Option B will have a major opportunity cost if it fails.

Example of Opportunity Cost

Example of Opportunity Cost

Whenever you make a significant purchase like buying a home or starting a business, you will probably thoroughly research the pros and cons, but many day-to-day decisions aren’t made with a full understanding of the opportunity costs.

Before making a purchase, many people check the balance in their savings account when they are feeling cautious.

When they make that spending decision, they don’t often consider the things they must sacrifice.

When you do not consider what other things you could do with your money or what other things you could buy, the problem arises.

Sometimes you should consider ordering takeout for lunch, especially if it gets you out of the office for a much-needed break.

The problem, however, would be if you bought a cheeseburger every day for the next 25 years.

The $4.50 spent on a burger could add up to just over $52,000 in that time frame, even without considering the missed opportunity for better health.

The core message in this example applies to a wide range of situations. Every time you want a candy bar or plan a vacation, you should think about opportunity costs.

Opportunities costs arise with every decision, big or small.

What Is a Simple Definition of Opportunity Cost?

Investing opportunities are often overlooked by investors. The hidden cost is essentially the cost of not taking an alternative course of action.

An organization might ignore the advantages of alternative strategies without first evaluating the merits of their current strategy, thereby failing to realize the opportunity costs and the possibility that they could have done even better had they chosen another path.

Is Opportunity Cost a Real Cost?

The opportunity cost does not directly appear on a company’s financial statements. However, opportunity costs are very real economically.

Due to the abstract nature of opportunity cost, corporations, executives, and investors fail to account for it in their day-to-day decisions.

What Is an Example of Opportunity Cost?

Consider an investor whose parents encouraged them to spend all of their disposable income on bonds when they were 18 years old.

This investor invested $5,000 annually in bonds for 50 years, earning an average annual return of 2.50% and retiring with a portfolio worth nearly $500,000.

It might seem impressive, but when the investor’s opportunity cost is factored in, the result is less impressive.

They would have earned more than $1 million if, instead, half of their money was invested in the stock market and an average blended return of 5% was received.

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