What Is Opportunity Cost?
Opportunity cost refers to the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. Opportunity costs represent the inherent trade-offs associated with decision-making.
How to Calculate Opportunity Cost?
Opportunity cost can be calculated using the following formula:
Opportunity Cost = Return of Forgone Option (FO) – Return of Chosen Option (CO)
For example, if an investor is choosing between Stock A, which is expected to return 7%, or Stock B expected to return 10%, the opportunity cost of choosing Stock A is 3% (the return of the forgone Stock B less the return of the chosen Stock A).
Why Opportunity Cost Matters?
Understanding opportunity costs is crucial for making informed decisions, especially in the business and investing spheres. Opportunity cost analysis allows individuals and businesses to compare the relative value of the choices in front of them. Here are some reasons why opportunity costs matter:
- Evaluating trade-offs: Opportunity cost quantifies what is being sacrificed in pursuit of another option. This allows for an “apples to apples” comparison.
- Allocating resources: Limited resources mean choices must be made. Analyzing opportunity cost guides optimal resource allocation.
- Assessing capital projects: Major investments like building a new factory involve an analysis of all associated opportunity costs. For example, a company could evaluate the opportunity cost of manufacturing the same goods with a third party.
- Managing investment portfolios: Investors weigh opportunity costs to make asset allocation decisions and sell vs. hold decisions.
Every decision has an opportunity cost attached to it. Recognizing explicit and implicit opportunity costs leads to better-informed choices.
Opportunity Cost vs. Sunk Cost
Opportunity cost differs from sunk cost. Sunk costs are expenses already incurred by the financial decisions you make that cannot be recovered. Opportunity costs represent potential benefits not realized from the next-best alternative.
Example of Opportunity Cost
Imagine a company considering two potential projects:
Project A is expected to generate $250,000 in annual profit while Project B is expected to generate $275,000 in annual profit as well as teach employees a new valuable skill.
If the company only has the resources to undertake one project, the opportunity cost of selecting Project A is $25,000 and that valuable skill (the forgone value from Project B).
This analysis helps measure the trade-off of going with one alternative over the other. The opportunity cost concept applies to virtually all decisions made by individuals, businesses, and investors. Unfortunately, it’s often much less clear cut than this example and are usually based on various probabilities of success and estimates instead of an assured profit.