What Is Opportunity Cost?

What Is the Meaning of Opportunity Cost?

The potential gains that an individual, investor, or organization misses out on when choosing one option over another are referred to as opportunity costs. Because opportunity costs are invisible by definition, they are easy to overlook. Understanding the opportunities that may be missed when a company or individual chooses one investment over another aids for more informed decision-making.

Important Points to Remember

• The benefit that might have been gained if a different alternative had been chosen is known as opportunity cost.
• To correctly assess opportunity costs, each option’s costs and advantages must be analyzed and weighed against the others.
• Individuals and businesses can make more profitable decisions by considering the value of opportunity costs.
Opportunity Cost Formula and Calculation

Opportunity Cost = FO − CO where: FO = Return on best forgone option CO = Return on chosen option begin{aligned} &text{Opportunity Cost}=text{FO}-text{CO} \&textbf{where:} \&text{FO}=text{Return on best forgone option} \&text{CO}=text{Return on chosen option} \end{aligned} ​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. Assume you choose option A, which is to invest in the stock market in the hopes of earning capital gains. Meanwhile, Option B is to put your money back into the business, with the expectation that better equipment will improve production efficiency, resulting in lower operating costs and a bigger profit margin.

Assume that the stock market’s estimated return on investment is 12 percent over the next year, and that your company expects a 10 percent return on the equipment upgrade over the same time period. The opportunity cost of choosing equipment over the stock market is 12 percent minus 10%, or two percentage points. To put it another way, investing in the firm means foregoing the chance to generate a larger return.

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

What the Cost of Opportunity Can Tell You

When it comes to evaluating a company’s capital structure, opportunity cost analysis is critical. When a company issues debt or equity capital, it incurs a cost to compensate lenders and shareholders for the risk of investment, but it also has an opportunity cost.

Loan payments, for example, cannot be invested in stocks or bonds, which give the possibility of earning an investment return. The corporation must evaluate whether expanding through debt leverage will yield more profits than it might through investing.

A company strives to balance the costs and benefits of issuing debt and equity, taking into account both monetary and nonmonetary factors, in order to find the best balance that minimizes opportunity costs. Because opportunity cost is a forward-looking factor, the current rate of return for both options is uncertain, making this analysis difficult in practice.

Assume the corporation in the preceding case foregoes new equipment in favor of stock market investments. If the value of the chosen securities falls, the corporation may lose money instead of earning the promised 12 percent return.

Assume that the investment provides a 0% return, indicating that the corporation gets back exactly what it put in. The opportunity cost of picking this option is 10% to 0% or 10%. It’s also feasible that if the corporation had chosen new equipment, manufacturing efficiency would have remained unchanged and profits would have remained stable. Choosing this choice has a 12 percent opportunity cost rather than the predicted 2 percent.

It’s crucial to weigh the pros and cons of investment options with similar risks. When a Treasury bill, which is nearly risk-free, is compared to an investment in a highly volatile stock, the results can be misleading. Although both choices are predicted to earn 5%, the T-rate bill’s of return is guaranteed by the US government, whereas there is no such guarantee in the stock market. While both options have the same opportunity cost of 0%, the T-bill is the safer bet when the relative risk of each investment is considered.

Investing comparisons

Businesses search for the option that is most likely to generate the highest return when evaluating the potential profitability of various investments. They can usually figure this out by looking at an investment vehicle’s estimated rate of return (RoR). Businesses must, however, take into account the opportunity cost of each alternative option.

Assume a company has $20,000 and must choose between putting it in securities or purchasing new machinery. The opportunity cost is the potential profit lost by not investing in the other option, regardless of which choice the company picks. If the company chooses the first option, its investment will be worth$22,000 at the end of the first year. [(Current Value – Initial Value) / Current Value] * 100 is the formula for calculating RoR. In this case, [($22,000 –$20,000) / $20,000] * 100 = 10%, indicating a 10% return on investment. Let’s assume it makes a 10% profit every year after that for the sake of this example. With a ten percent return on investment and compounding interest, the investment will grow by$2,000 in the first year, $2,200 in the second year, and$2,420 in the third year.

Alternatively, if the company invests in a new machine, it will be able to boost its widget production. The machine setup and employee training will be time-consuming, and the new equipment will not be operating at full capacity for the first few years. Let’s say that after accounting for the higher training costs, the company will make an extra $500 in profits in the first year. The company will make$2,000 in the second year and $5,000 in subsequent years. The corporation must choose between the two options because it has limited finances to invest in either. The opportunity cost for selecting securities makes sense in the first and second years, according to this. However, an examination of the opportunity cost shows that the new machine is the better alternative after the third year ($500 + $2,000 +$5,000 – $2,000 –$2,200 – $2,420) =$880.