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.

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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.

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What Is the Difference Between Sunk Cost and Opportunity Cost?

A sunk cost is money that has already been spent, but an opportunity cost is the potential return on an investment that will not be realized in the future because the capital was invested elsewhere.

Purchasing 1,000 shares of firm A at $10 per share, for example, is a $10,000 sunk cost. This is the amount of money put out to invest, and the only way to recoup that money is to sell stock at or above the purchase price. Instead, the potential cost considers how that $10,000 may have been better spent.

A sunk cost can also refer to the initial outlay for an expensive piece of heavy equipment, which may be amortized over time but is sunk in the sense that it will not be recovered.

When deciding between a piece of heavy equipment with a 5-percent expected return on investment (ROI) and one with a 4-percent expected return on investment (ROI), evaluate the potential forgone returns elsewhere.

An opportunity cost, once again, is the return that could have been generated if the money had been invested in a different instrument. While 1,000 shares of business A would eventually sell for $12 a share, generating a profit of $2,000, company B’s value climbed from $10 to $15 during the same time period.

In this case, investing $10,000 in company A yielded $2,000, whereas investing the same amount in firm B yielded $5,000. The difference of $3,000 is the opportunity cost of choosing company A versus company B.

If you’ve already put money into investments, you might be able to discover a new one that offers better returns. The opportunity cost of holding the underperforming asset may escalate to the point where selling and investing in a more promising asset is the reasonable investment alternative.

Risk and Opportunity Cost

In economics, risk refers to the chance that the actual and predicted returns on an investment differ and that the investor loses some or all of his or her money. The potential that the rewards on a chosen investment will be lower than the returns on a forgone investment is known as opportunity cost.

The main distinction is that risk compares an investment’s actual performance to its expected performance, whereas opportunity cost compares an investment’s actual performance to the actual performance of another investment.

Even yet, when picking between two risk profiles, opportunity costs should be considered. If investment A is dangerous but has a 25% return on investment, but investment B is significantly less risky but only has a 5% return on investment, investment A may or may not succeed. If it fails, the opportunity cost of choosing option B will be significant.

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Opportunity Cost as an Example

Most day-to-day decisions aren’t made with a complete grasp of the potential opportunity costs. Before making large decisions like buying a home or establishing a business, you’ll undoubtedly conduct thorough study into the benefits and drawbacks of your financial decision.

Many people, for example, may check the balance of their savings account before making a purchase if they are unsure. When people make that spending decision, however, they rarely consider the items they will have to give up.

The issue arises when you never think what else you could do with your money or buy goods without realizing the opportunity you’ve missed up on. Occasionally ordering takeaway for lunch can be a good idea, especially if it takes you out of the office for a much-needed break.

Purchasing one cheeseburger every day over the next 25 years, on the other hand, could result in a number of missed opportunities. Aside from the wasted opportunity for better health, spending $4.50 on a burger over the course of a year might add up to little over $52,000, assuming a very achievable 5% rate of return.

This is a simple example, but the message is applicable to a wide range of circumstances. Considering opportunity costs every time you want to buy a candy bar or go on vacation may seem excessive. Opportunity costs, on the other hand, are present in every decision, big or small.

What Does Opportunity Cost Mean in Simple Terms?

Investors sometimes underestimate opportunity cost. In essence, it refers to the hidden cost of failing to take a different path of action. If a corporation pursues a certain business plan without first weighing the benefits of competing strategies, they may overlook their opportunity costs and the chance that they could have done even better had they taken a different path.

Is the cost of opportunity a real cost?

The cost of opportunity does not shown on a company’s financial statements. However, opportunity costs are still quite substantial in terms of economics. However, because opportunity cost is such a vague term, many businesses, executives, and investors fail to consider it in their daily decisions.

What Does an Opportunity Cost Look Like?

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

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