What is opportunity cost

What Is Opportunity Cost?

Gordon Scott has been an active investor and technical analyst of securities, futures, forex, and penny stocks for 20+ years. He is a member of the Investopedia Financial Review Board and the co-author of Investing to Win. Gordon is a Chartered Market Technician (CMT). He is also a member of CMT Association.

The Balance / Maddy Price

Opportunity cost is the amount of potential gain an investor misses out on when they commit to one investment choice over another.

Definition and Examples of Opportunity Cost

Opportunity cost is the value of what you lose when choosing between two or more options. When you decide, you feel that the choice you’ve made will have better results for you regardless of what you lose by making it. As an investor, opportunity cost means that your investment choices will always have immediate and future losses or gains.

Consider, for example, the choice between whether to sell stock shares now or hold onto them to sell later. While it is true that an investor could secure any immediate gains they might have by selling immediately, they lose out on any gains the investment could bring them in the future.

Another example of opportunity cost is something as simple as choosing between going to work and skipping work. What are you losing out on if you choose one over the other? Opportunity cost doesn’t always need to apply to investments or money; it can also apply to life decisions.

How Opportunity Cost Works

When you’re faced with a financial decision, you can try to determine the return you’ll get from each option. For example, let’s say you’re entertaining the thought of selling a bond and using the money you’ll gain to purchase another. You could visualize the opportunities using this table:

Comparing these measures in hindsight will make them appear more concrete, but keep in mind that such an estimation is only a theoretical difference.

How To Calculate Opportunity Cost

While opportunity cost is not an exact measure, one way to quantify it is to estimate the potential future value that you opted not to receive and compare it with the value of the choice you made instead.

Here’s a formula for calculating opportunity cost:

On a basic level, opportunity cost is a common-sense concept that economists and investors like to explore. For example, what would have happened if Walt Disney had never started animating? He might have gone on to do something equally successful, or you may never have heard his name.

Opportunity cost is the proverbial fork in the road, with dollar signs on each path—the key is, there is something to gain and lose in each direction. You make an informed decision by estimating the losses for each decision.

What Opportunity Cost Means for You

If you have trouble understanding the premise, remember that opportunity cost is inextricably linked with the notion that nearly every decision requires a trade-off. We live in a finite world—you can’t be two places at once.

Every choice made in life has an opportunity cost.

Explicit Costs

For investors, explicit costs are direct, out-of-pocket payments such as purchasing a stock or an option, or spending money to improve a rental property. Costs can also be wages, utilities, materials, or rent.

Explicit and implicit costs can be viewed as out-of-pocket costs (explicit) and costs of using assets you own (implicit).

Implicit Costs

Implicit costs do not represent a financial payment. They’re not direct costs to you but rather the lost opportunity to generate income through your resources.

If you have a second house that you use as a vacation home, for instance, the implicit cost is the rental income you could have generated if you leased it and collected monthly rental checks when you’re not using it. It doesn’t cost you anything upfront to use the vacation home yourself, but you are giving up the opportunity to generate income from the property if you choose not to lease it.

Key Takeaways

Frequently Asked Questions (FAQs)

What is the simple definition of opportunity cost?

Opportunity cost is the value of what you lose when choosing between two or more options. Every choice has trade-offs, and opportunity cost is the potential benefits you’ll miss out on by choosing one direction over another.

Why does opportunity cost matter?

Understanding opportunity cost can help you make better decisions. When you fully understand the potential costs and benefits of each option you’re weighing, you can make a more informed decision and be better prepared for any consequences of your choice.

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Opportunity Cost – Meaning, Importance, Calculation And More

Meaning of Opportunity Cost

Opportunity Cost means the cost or price of the next best alternative available to a business, company, or investor. The next best choice refers to the option which has been foregone and not been chosen. Instead, another option, assuming it to be better and more rewarding and fruitful, has been selected. In other words, Opportunity Cost is the cost of the sacrifice of an available opportunity.

One important thing to keep in mind is the presence and availability of a feasible “option” to the decision-maker. If there is no option available, then there is no Opportunity Cost. Further, the available options should have an economic value. The foregone option may be a product or a service. These options can be anything- from taking production decisions to investment decisions. Also, they can be making a purchase decision to even valuing time spent on a particular activity.

Explicit and Implicit Cost

Explicit costs are the costs that a person or an entity incurs to avail of the benefit of an activity or service, or product. For example, if a producer gives US$50 as labor charges for a product, the explicit Cost is US$50. It means that the producer has lost an opportunity to spend this amount to buy some other product or service.

On the other hand, implicit opportunity costs are the costs that are notional or implied in nature. They are the costs of not choosing an available option. For example, the inherent opportunity cost of setting up a production unit is the loss of opportunity to invest the same amount of money in real estate and sell it after that.

Importance of Opportunity Cost

The concept of Opportunity Cost is crucial in the world of business and finance. It explains the rationale of the economic decisions taken or chosen regarding the other available options.

Production

Opportunity Cost provides a vital direction and guidance while deciding what to produce. It throws light on the following aspects:

Investing

The concept of Opportunity cost is essential for making investments and related decisions.

Calculation and Example

Opportunity Cost can simply be calculated by comparing the financial Cost of the next best possible option that has been foregone.

Similarly, the opportunity cost of investing in Stock A for US$100 will be the loss of Opportunity of investing in Stock B for the same amount. If stock A rallies to US$150, and stock B remains the same in value, the investor gains US$50, and his decision to go for stock A is justified.

Conclusion

The world has limited availability of resources like land, labor, and capital. This scarcity of resources makes it very important to use a resource most efficiently and achieve maximum returns. The concept of Opportunity Cost helps us to choose the best possible option among all the available options. It helps us use every possible resource tactfully and efficiently and hence, maximize economic profits.

Quiz on Opportunity Costs

This quiz will help you to take a quick test of what you have read here.

Opportunity Cost

Investopedia / Mira Norian

What Is Opportunity Cost?

Opportunity costs represent the potential benefits that an individual, investor, or business misses out on when choosing one alternative over another. Because opportunity costs are unseen by definition, they can be easily overlooked. Understanding the potential missed opportunities when a business or individual chooses one investment over another allows for better decision making.

Key Takeaways

Opportunity Cost

Formula and Calculation of Opportunity Cost

The formula for calculating an opportunity cost is simply the difference between the expected returns of each option. Consider a company is faced with the following two mutually exclusive options:

Option A: Invest excess capital in the stock market to potentially earn capital gains.

Option B: Invest excess capital back into the business for new equipment to increase production efficiency.

While financial reports do not show opportunity costs, business owners often use the concept to make educated decisions when they have multiple options before them. Bottlenecks, for instance, often result in opportunity costs.

What Opportunity Cost Can Tell You

Opportunity cost analysis plays a crucial role in determining a business’s capital structure. A firm incurs an expense in issuing both debt and equity capital to compensate lenders and shareholders for the risk of investment, yet each also carries an opportunity cost.

Funds used to make payments on loans, for example, cannot be invested in stocks or bonds, which offer the potential for investment income. The company must decide if the expansion made by the leveraging power of debt will generate greater profits than it could make through investments.

A firm tries to weigh the costs and benefits of issuing debt and stock, including both monetary and nonmonetary considerations, to arrive at an optimal balance that minimizes opportunity costs. Because opportunity cost is a forward-looking consideration, the actual rate of return (RoR) for both options is unknown today, making this evaluation tricky in practice.

Assume that the company in the above example forgoes new equipment and instead invests in the stock market. If the selected securities decrease in value, the company could end up losing money rather than enjoying the expected 12% return.

For the sake of simplicity, assume that the investment yields a return of 0%, meaning the company gets out exactly what is put in. The opportunity cost of choosing this option is 10% to 0%, or 10%. It is equally possible that, had the company chosen new equipment, there would be no effect on production efficiency, and profits would remain stable. The opportunity cost of choosing this option is then 12% rather than the expected 2%.

It is important to compare investment options that have a similar risk. Comparing a Treasury bill, which is virtually risk free, to investment in a highly volatile stock can cause a misleading calculation. Both options may have expected returns of 5%, but the U.S. government backs the RoR of the T-bill, while there is no such guarantee in the stock market. While the opportunity cost of either option is 0%, the T-bill is the safer bet when you consider the relative risk of each investment.

Comparing Investments

When assessing the potential profitability of various investments, businesses look for the option that is likely to yield the greatest return. Often, they can determine this by looking at the expected RoR for an investment vehicle. However, businesses must also consider the opportunity cost of each alternative option.

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The Difference Between Opportunity Cost and Sunk Cost

A sunk cost is money already spent in the past, while opportunity cost is the potential returns not earned in the future on an investment because the capital was invested elsewhere. When considering opportunity cost, any sunk costs previously incurred are ignored unless there are specific variable outcomes related to those funds.

From an accounting perspective, a sunk cost also could refer to the initial outlay to purchase an expensive piece of heavy equipment, which might be amortized over time, but which is sunk in the sense that you won’t be getting it back.

As an investor who has already put money into investments, you might find another investment that promises greater returns. The opportunity cost of holding the underperforming asset may rise to the point where the rational investment option is to sell and invest in the more promising investment.

Opportunity Cost and Risk

In economics, risk describes the possibility that an investment’s actual and projected returns are different and that the investor loses some or all of the principal. Opportunity cost concerns the possibility that the returns of a chosen investment are lower than the returns of a forgone investment.

The key difference is that risk compares the actual performance of an investment against the projected performance of the same investment, while opportunity cost compares the actual performance of an investment against the actual performance of another investment.

Still, one could consider opportunity costs when deciding between two risk profiles. If investment A is risky but has an ROI of 25%, while investment B is far less risky but only has an ROI of 5%, even though investment A may succeed, it may not. If it fails, then the opportunity cost of going with option B will be salient. Therefore, decision-makers rely on much more information than just looking at just opportunity cost dollar amounts when comparing options.

In 1962, a little known band called The Beatles auditioned for Decca Records. The label decided against signing the band. This decision would have been made because the opportunity cost to sign them did not outweigh the opportunity cost to pass on them.

Economic Profit and Accounting Profit

Opportunity cost is used to calculate different types of company profit. The most common type of profit analysts are familiar with is accounting profit. Accounting profit is the net income calculation often stipulated by Generally Accepted Accounting Principles (GAAP). Only explicit, real costs are subtracted from total revenue.

Companies or analysts can future manipulate accounting profit to arrive at an economic profit. The difference between the calculation of the two is economic profit includes opportunity cost as an expense. This theoretical calculation can then be used to compare the actual profit of the company to what the theoretical profit would have been.

Economic profit (and any other calculation above that considers opportunity cost) is strictly an internal value used for strategic decision-making. There are no regulatory bodies that govern public reporting of economic profit or opportunity cost. Whereas accounting profit is heavily dictated by reporting rules and frameworks, economic profit factors in vague assumptions and estimates from management that do not have IRS, SEC, or FASB oversight.

Example of Opportunity Cost

Before making big decisions like buying a home or starting a business, you probably will scrupulously research the pros and cons of your financial decision, but most day-to-day choices aren’t made with a full understanding of the potential opportunity costs.

When feeling cautious about a purchase, for instance, many people will check the balance of their savings account before spending money. But they often won’t think about the things that they must give up when they make that spending decision.

The problem comes up when you never look at what else you could do with your money or buy things without considering the lost opportunities. Having takeout for lunch occasionally can be a wise decision, especially if it gets you out of the office for a much-needed break.

This is a simple example, but the core message holds for a variety of situations. It may sound like overkill to think about opportunity costs every time you want to buy a candy bar or go on vacation. But opportunity costs are everywhere and occur with every decision made, big or small.

What Is a Simple Definition of Opportunity Cost?

Opportunity cost is often overlooked by investors. In essence, it refers to the hidden cost associated with not taking an alternative course of action. If, for example, a company pursues a particular business strategy without first considering the merits of alternative strategies available to them, they might fail to appreciate their opportunity costs and the possibility that they could have done even better had they chosen another path.

Is Opportunity Cost Real?

Opportunity cost does not show up directly on a company’s financial statements. Economically speaking, though, opportunity costs are still very real. Yet because opportunity cost is a relatively abstract concept, many companies, executives, and investors fail to account for it in their everyday decision making.

What Is An Example of Opportunity Cost?

How Do You Determine Opportunity Cost?

The downside of opportunity cost is it is heavily reliant on estimates and assumptions. There’s no way of knowing exactly how a different course of action may have played out financially. Therefore, to determine opportunity cost, a company or investor must project the outcome and forecast the financial impact. This includes projecting sales numbers, market penetration, customer demographics, manufacturing costs, customer returns, and seasonality.

This complex situation pinpoints the reason why opportunity cost exists. It may not be immediately clear to a company the best course of action; however, after retrospectively assessing the variables above, they may further understand how one option would have been better than the other and they have incurred a «loss» due to opportunity cost.

How To Calculate Opportunity Cost (With Examples)

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There’s no doubt that investing can be a nerve-wracking and tricky business. However, with the right precautions, it can also be extremely profitable. To minimize risks and maximize profits, investors often use various tricks of the trade to calculate and compare potential decisions.

One of these valuable tools is comparing one economical choice to the next, otherwise known as opportunity cost. When investors aren’t sure whether they want to stick with one option or pursue the next best option, opportunity cost can be used to calculate the impact of choosing one investment over another.

In general, opportunity cost is an important part of estimating the economic effect of choosing one investment option over the other. Therefore, it can serve investors in a variety of situations.

With that in mind, this article will serve as a guide to understanding opportunity cost by explaining how it’s calculated and why it can be beneficial, as well as providing real-life examples of its use.

What Exactly Is Opportunity Cost?

As mentioned, opportunity cost is a comparison used to help investors, or anyone really, make intelligent financial decisions. After all, it takes a lot of thought to discern how making one purchase over another will affect your return on investment.

Therefore, opportunity cost represents the cost of inevitably choosing one option over the other, whereby the measurement becomes the metric you can use to make a decision.

Opportunity cost as a concept is versatile and can be applied to anything from small financial decisions made by individuals to large decisions made by businesses regarding production, time management, and capital allocation. Truly, anyone can make use of the figure.

For instance, the trade-off cost of choosing to invest in a yacht over a sailboat can be estimated through how choosing one over the other will affect your savings account. Ultimately, opportunity cost attempts to assign a measurable figure to such a trade-off.

In simpler terms, an opportunity cost is essentially the cost of the option you don’t choose.

When and Where Opportunity Cost Calculations Are Useful

Whether you’re an entrepreneur making millions, or a first-year college student, opportunity cost is a versatile calculation that can be applied to countless situations. Some common scenarios in which an opportunity cost figure could be insightful include:

Choosing which stock to invest in on the stock market. For investors, making a well-educated gamble on which stock to invest in can make or break their wallets. Therefore, opportunity cost can be a valuable measurement to use when comparing two different stocks.

Weighing the pros and cons of one possible purchase over the other. Suppose you’re thinking about whether or not you want to buy an expensive piece of furniture that’s more durable or a cheap piece of furniture with a shorter lifespan. In that case, you can use opportunity cost to figure out which one might be a better investment.

Deciding where to allocate business funds. Businesses require thoughtful management, and opportunity costs can be used to assess which investments will be more profitable than others.

Measuring the value of your time. Time is money, as they say. Especially for business owners, having the time to work on their business makes them money. Therefore, opportunity cost can be used to measure the cost of lost time.

Opportunity Cost Formula

Given the versatility of the concept, opportunity cost doesn’t have a clearly defined or designated formula. Instead, there is a common mathematical method for assessing it and coming up with useful figures. This method is as follows:

Opportunity Cost = Return on Foregone Alternative Option − Return on Chosen Option

Keep in mind that opportunity cost can be a positive or negative number. When negative, you could potentially lose more from your chosen option than you would from the alternative, whereas a positive number indicates a more profitable move.

Of course, this calculation is made much more accurate with the benefit of hindsight but can still provide useful insight into possible options currently being considered.

Opportunity Cost Examples

To further understand opportunity cost, here are two examples of different situations that outline its use:

To apply opportunity cost to typical investments, imagine that an investor could choose between investing in Apple or Tesla. At the time, he chose Apple, as the company seemed to have steady stock growth of 87%.

However, Tesla’s stock value increased at a much more exponential 542%. This means that ultimately, the investor’s opportunity cost was 455%. (542% – 87% = 455%)

Opportunity Cost and Risk

While opportunity cost isn’t the same as risk, the two concepts provide a similar outlook on investments. Risk outlines the possibility that the return on investment (ROI) will be different than its initial predicted one, resulting in a loss of profit.

On the other hand, opportunity cost relates to the idea that the returns of a chosen investment will potentially be lower than the returns of the next best option.

While both risk and opportunity cost address a potential loss, risk compares the potential performance of an investment against itself, while opportunity cost compares the performances of two different investments.

However, it’s important to note that opportunity cost can aid in deciding between two risk profiles. For example, let’s say you have the option between investment #1, which is rather precarious, but has a possible ROI of 21%, or investment #2, which is considerably less risky, but only has an ROI of 7%.

Though you’d be making far more money if #1 succeeds, you could also lose everything due to the high risk of failure. Therefore, if option #1 were to fail, there would be a significant opportunity cost associated with choosing it over option #2.

Important Limitations on Opportunity Cost

As suggested by the concept of risk, there are important limitations to opportunity cost figures. Truly, there will never be an instance where you can predict the outcome of an investment with 100% accuracy.

After all, when you’re comparing the long-term cost of two things you haven’t purchased yet, you’re bound to see a variation in your results. Over time you might find that your initial calculation was inaccurate, especially when working with something volatile like the stock market.

Additionally, if you were to compare the income you’ve lost from something like choosing to take time off work to earn your Bachelor’s degree, it can be difficult to factor all of the trade-offs accurately.

You have to consider time lost, wages lost, college cost, and the potential earnings increase you might see after achieving your degree. When calculating all of these factors, it’s incredibly easy for inaccuracies to emerge.

With that in mind, you shouldn’t expect perfect results, as regardless of how accurate your opportunity cost measurement was, the simple fact that you’re considering figures when purchasing something indicates that you’re making thoughtful financial decisions.

Setting Future Goals for Your Career

Opportunity cost is a valuable financial tool you can use to understand the benefits and downsides of choosing one investment option over the other, thus allowing you to plan for the future. Opportunity cost figures can give you insight into the direction you want to go in and guide your financial decision-making.

Think about where you see yourself in a year, or even five years. Imagine how certain investments will affect your life later down the line. Especially if you have a specific financial goal in mind, it’s important to make plans to help you achieve that goal.

For instance, if you’re currently thinking of buying a new car, you can use opportunity cost to identify the pros and cons of possible purchases. Maybe you want an inexpensive sedan, but there’s admittedly more value in a larger SUV. An opportunity cost calculation could help you navigate your decision-making, as there will undoubtedly be sacrifices to make either way.

In business-oriented situations, understanding opportunity can also allow you to make intelligent investments, even if differences are marginal. Over time, more thoughtful decision-making will help your business grow.

Ultimately, no matter what your current circumstances may be, it’s never too late to start using opportunity cost as a tool for setting and achieving future financial goals.

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What is Opportunity Cost

Concept of Opportunity Cost

Opportunity cost is commonly defined as the next best alternative. Also, known as the alternative cost, it is the loss of gain which could have been gained if another alternative was chosen. It can also be explained as the loss of benefit due to a change in choice.

Opportunity cost is an economic concept arising out of the realistic assumption of the scarcity of resources. The limited amount of resources will also limit the number of possibilities for production. As the number of possibilities of production is limited, to produce a given combination of goods, the production of another combination of goods would have to be forgotten. This can be referred to as opportunity cost.

Opportunity cost is a concept that is widely used by promoters and business analysts to conduct feasibility studies as well as to ascertain policy decisions to be taken.

Opportunity Cost of Decisions

Every opportunity cost is due to a faulty decision. The better the decision is, the smaller the opportunity cost will be. An opportunity cost can be found in any daily activity. The homework you did not do could be the opportunity cost of sleeping more. Even though you prefer sleeping, the homework makes you more productive and may fetch you more marks.

In economics, the opportunity cost of decisions generally pertains to the opportunity cost arising due to the decisions of the firm in production. This decision on the choice of production occurs due to the scarcity of resources. For example, a farmer has a fixed area of land in which she cultivates different crops. If the farmer sows rice at a particular time, she can’t produce wheat now as she has already used up her land to produce rice. The gain that the farmer would have earned by cultivating wheat over and above her earnings by sowing rice is her opportunity cost.

Calculation of Opportunity Cost

Opportunity cost is the extra return on an alternative available over and above the chosen option.

Therefore, Opportunity cost = Return from the best alternative – Return from the already selected option

This calculation of opportunity cost has a wide range of applications. Most prominently being used in product planning decisions, the concept of opportunity cost is relevant in many other business scenarios. The calculation method is used when prices paid to factor services are determined and also to calculate economic rent, which is the difference between the actual return to factor services and their supply price.

The calculation of opportunity cost is not only applicable to the producers. The consumers also use the method of opportunity cost to weigh different consumption bundles among each other.

Types of Opportunity Costs

There are broadly two types of opportunity costs. They are explicit costs and implicit costs.

Explicit costs are as the name suggests direct costs that can be identified clearly. The explicit costs are incurred and recorded in the books of accounts. These explicit costs would have to be paid in cash or kind. For example, if a piece of machinery in the firm malfunctions, the repairing cost is explicit. The repairing and reinstalling work will have to be paid in cash and the transaction is charged in the books of accounts as an expenditure.

Implicit costs are indirect or invisible costs that cannot be directly or easily traced down. The implicit costs affect the firm as the loss of its owned resources. Payments are not usually made as there is no real cost. For example, if in a firm a piece of machinery breaks down as mentioned earlier, in addition to the cost of repairing which is an explicit cost there is also an implicit cost of loss in production. The production in that unit is stalled as the machinery is not working and, in the meantime, other valuable resources like human resources are being wasted.

What is the Increasing Opportunity Cost?

The concept of increasing opportunity cost is usually seen in the production possibility frontier which shows the possibility of production of different bundles of two goods using a limited amount of resources. The Production Possibility Frontier is concave to the origin and its slope is the opportunity cost. As the PPF is concave to the origin, it shows how the opportunity cost of producing more of one good continuously increases. This increasing nature of opportunity cost is generally explained in terms of the inefficiency of resources when put to work to produce more than one kind of good.

For example, in an economy, steel can be used for making utensils as well as weapons. As more and more steel is used in the production of weapons and less on utensils, the opportunity cost goes on decreasing. This is because the amount of other resources employed in the production of weapons, namely machinery, is fixed and as more and more steel is fed into the limited amount of machinery, it becomes inefficient.

Introduction to Opportunity cost

It was firstly introduced by the 18th-century economist, Adam Smith. When it comes to opportunity cost, there are three factors that you need to take into account: The value of the option that you’re giving up; The likelihood of achieving the desired outcome; And your level of certainty about both options. Opportunity cost is important because it helps us make better decisions and encourages us to think about the future for example when choosing a course of action in business. It can also help determine whether or not pursuing something particular is worth doing based on its potential benefits and what we might have to sacrifice instead.

Opportunity Cost is Important Because

1. It’s a measure of the cost of alternatives like sacrificing short-term profits

2. It is used to analyze the potential of an opportunity

3. And it can help you determine whether or not a particular course of action is worth pursuing.

4. It can help you make better decisions

5. It helps to assess opportunity costs and benefits.

6. It encourages you to think about the future.

Here are Some Tips to Study Opportunity Cost

1) Know the Basics- Before starting studying the concept, it is important to have a clear understanding of what it is all about and be familiar with the common terminologies. Which will help you focus on the concept itself.

3) You need to make sure that the correct time period is used. When choosing your timing for opportunity cost calculations, it’s important to consider how long an activity takes and when its benefits begin.

4) You should always use real numbers instead of percentages or fractions in order to simplify the calculation and avoid confusion.

5) Avoid Cramming- When it comes to studying, especially for something like opportunity cost where there are a number of complex terms. It is best to make sure that you write them down and understand the concept fully before moving on.

6) Practice Makes Perfect- It is important to practice the calculation because there are a number of different ways to calculate opportunity cost. There are online calculators that you can use or even practice problems to help you better understand the concept.

It is Applied in Various Ways

Opportunity cost is a basic economic principle that applies to businesses as well. It’s important to learn and understand the concept in order to make better decisions for your business. The best way to do this is by studying and practicing, which will help you get a clear understanding of how it works.