What Is Opportunity Cost?
Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. Because opportunity costs are, by definition, unseen, 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.
- Opportunity cost is the forgone benefit that would have been derived from an option not chosen.
- To properly evaluate opportunity costs, the costs and benefits of every option available must be considered and weighed against the others.
- Considering the value of opportunity costs can guide individuals and organizations to more profitable decision-making.
Formula and Calculation of Opportunity Cost
Opportunity Cost=FO−COwhere:FO=Return on best forgone optionCO=Return on chosen option
The formula for calculating an opportunity cost is simply the difference between the expected returns of each option. Say that you have option A—to invest in the stock market hoping to generate capital gain returns. Meanwhile, Option B is to reinvest your money back into the business, expecting that newer equipment will increase production efficiency, leading to lower operational expenses and a higher profit margin.
Assume the expected return on investment in the stock market is 12% over the next year, and your company expects the equipment update to generate a 10% return over the same period. The opportunity cost of choosing the equipment over the stock market is (12% - 10%), which equals two percentage points. In other words, by investing in the business, you would forgo the opportunity to earn a higher return.
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 for both options is unknown today, making this evaluation tricky in practice.
Assume 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 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 rate of return 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.
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 rate of return (RoR) for an investment vehicle. However, businesses must also consider the opportunity cost of each alternative option.
Assume that, given $20,000 of available funds, a business must choose between investing funds in securities or using it to purchase new machinery. No matter which option the business chooses, the potential profit it gives up by not investing in the other option is the opportunity cost.
If the business goes with the first option, at the end of the first year, its investment will be worth $22,000. The formula to calculate RoR is [(Current Value - Initial Value) / Current Value] * 100. In this example, [($22,000 - $20,000) / $20,000] * 100 = 10%, so the RoR on the investment is 10%. For the purposes of this example, let's assume it would net 10% every year after as well. At a 10% RoR, with compounding interest, the investment will increase by $2,000 in year 1, $2,200 in year 2, and $2,420 in year 3.
Alternatively, if the business purchases a new machine, it will be able to increase its production of widgets. The machine setup and employee training will be intensive, and the new machine will not be up to maximum efficiency for the first couple years. Let's assume it would net the company an additional $500 in profits in the first year, after accounting for the additional expenses for training. The business will net $2,000 in year two and $5,000 in all future years.
Since the company has limited funds to invest in either option, it must make a choice. According to this, the opportunity cost for choosing the securities makes sense in the first and second years. However, by the third year, an analysis of the opportunity cost indicates that the new machine is the better option ($500 + $2,000 + $5,000 - $2,000 - $2,200 - $2,420) = $880.
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.
Buying 1,000 shares of company A at $10 a share, for instance, represents a sunk cost of $10,000. This is the amount of money paid out to invest, and getting that money back requires liquidating stock at or above the purchase price. But the opportunity cost instead asks where could have that $10,000 been put to better use.
From an accounting perspective, a sunk cost could also 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.
An opportunity cost would be to consider the forgone returns possibly earned elsewhere when you buy a piece of heavy equipment with an expected return on investment (ROI) of 5% vs. one with an ROI of 4%.
Again, an opportunity cost describes the returns that one could have earned if the money were instead invested in another instrument. Thus, while 1,000 shares in company A might eventually sell for $12 a share, netting a profit of $2,000, during the same period, company B increased in value from $10 a share to $15.
In this scenario, investing $10,000 in company A returned $2,000, while the same amount invested in company B would have returned a larger $5,000. The $3,000 difference is the opportunity cost of choosing company A over company B.
As an investor who has already sunk 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. And if it fails, then the opportunity cost of going with option B will be salient.
Example of Opportunity Cost
Before making big decisions like buying a home or starting a business, you will probably 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 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.
However, buying one cheeseburger every day for the next 25 years could lead to several missed opportunities. Aside from the missed opportunity for better health, spending that $4.50 on a burger could add up to just over $52,000 in that time frame, assuming a very achievable 5% rate of return.
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 a Real Cost?
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?
Consider the case of an investor who, at the age of 18, was encouraged by their parents to always put 100% of their disposable income into bonds. Over the next 50 years, this investor dutifully invested $5,000 per year in bonds, achieving an average annual return of 2.50% and retiring with a portfolio worth nearly $500,000. Although this result might seem impressive, it is less so when one considers the investor’s opportunity cost. If, for example, they had instead invested half of their money in the stock market and received an average blended return of 5%, then their retirement portfolio would have been worth more than $1 million.