What is the opportunity cost?
Opportunity cost lets you calculate, in simple mathematical terms, what you stand to lose by choosing either option. This provides a metric that you can use to measure the values of each option and then make a simple cost/benefit analysis. If you’re trying to create a budget, decide whether another few years of school is right for you, or find out how much “yes” is really costing you, the opportunity cost will help you cut straight to the chase and figure out where your goals lie. We also provided some instructions on how to measure the cost of opportunity, and how you can use such estimates to gain a greater sense of clarity.
Common types of opportunity costs
Implicit opportunity cost
This type of opportunity cost is an intangible cost that can not easily be compensated for. For example , if a company invests a large amount of time in non-profit work, the implied cost will be the money earned or lost by spending time on volunteering rather than working.
Explicit opportunity cost
This type of opportunity cost relates to the cost that is easily accounted for. Explicit costs are normally costs that can be counted, such as the dollar amount. For example , if a business spends $2,500 on new laptops for its employees, the explicit cost is what the organization would otherwise have done with $2,500, or what it would have avoided by spending $2,500 on laptops.
The opportunity cost can not be included in financial reports. However, companies may use the opportunity cost to make decisions that require a choice between several alternatives. Bottlenecks are a common source of opportunity costs for businesses producing goods.
How to calculate opportunity cost?
Due to the fact that opportunity costs are not always clearly identified or taken into account, the opportunity cost for a particular situation is not always a simple solution. However, some businesses use the following formula to calculate the opportunity costs when possible:
1.Opportunity Cost =Return on best foregone option – return on chosen option
2.Opportunity Cost(%) =What you sacrifice by making a choice / What you gain by making a choice
Opportunity Cost Example
If you will choose between buying stock in Company A and Company B . And you chooses to buy A. A year later, Company A has returned 4%, while B has returned 9%. In this case, you can clearly calculate the opportunity cost as 5% (9% – 4%).
Opportunity Cost Limitations
The main limitation of opportunity costs is that future returns are difficult to predict accurately. You can research historical data to get a better understanding of the performance of an investment, but can never estimate 100% accuracy of investment performance.
Consideration of the cost of opportunity is an essential part of decision-making, but it is not reliable until the choice has been made and you can look back and compare how the two decisions have been made.
Although the concept of opportunity cost applies to any decision, it is more difficult to calculate when you consider factors that can not be assigned a dollar amount. Say you’ve got two investment opportunities. One offers a conservative return, but only allows you to tie up your cash for two years, while the other does not allow you to touch your money for 10 years, but will pay higher interest with a slightly higher risk. For this scenario, the differences for liquidity would include part of the opportunity cost.
The biggest opportunity cost in terms of liquidity has to do with the chance that in the future you could miss a perfect investment opportunity because you can’t get your hands on your money that’s tied up in another investment. That’s a true opportunity cost, but with a dollar figure, it’s hard to calculate and it doesn’t fit cleanly into the calculation of opportunity cost.
When to use opportunity cost calculations?
Opportunity Cost can be used in almost any business decision. Use opportunity cost calculations helps business owners and other stakeholders to determine what could be the most important and efficient choice and see a foregone option return. Business owners should make the use of opportunity costs when making choices that will affect their businesses’ competitiveness and/or when determining the risks of an choice to calculate their potential returns.
Risk vs. Opportunity Cost
Risk in economics refers to the possibility that the actual and projected returns on investment differ and that the investor loses some or all of the principal. The possibility that the returns on a chosen investment will be lower than the returns on a forgone investment is referred to as opportunity cost. The key distinction is that risk compares an investment’s actual performance to its projected performance, whereas opportunity cost compares an investment’s actual performance to the actual performance of other investments.
Still, when deciding between two risk profiles, one should consider opportunity costs. If investment A is risky but has a 25% ROI while investment B is far less risky but only has a 5% ROI, investment A may succeed but it may not. And if it fails, the opportunity cost of choosing option B will be obvious.
The Bottom Line
- Opportunity cost measures the impact of making one investment/economic choice instead of another.
- While it’s often used by investors, opportunity cost can apply to any decision-making process.
- Opportunity cost can be used while making decisions, but it’s most accurate when comparing decisions that have already been made.