What is Opportunity Cost?
An opportunity cost is the value of an alternative choice that an individual, investor, or business misses out on when making another decision instead.
Every decision comes with a trade-off. Opportunity cost reveals the missed benefit of the choice you didn’t make. When you pick one option over the other, you get to enjoy the benefit of your decision. But, you also incur the opportunity cost of losing out on the choice you passed up. In other words, opportunity cost is the value of the next best alternative. It’s easy to overlook because it doesn’t act like an explicit cost. And while opportunity cost doesn’t show up on a company’s income statement or balance sheet, it’s still important to consider.
Let’s look at opportunity cost when deciding between two fields of work. One job lets you pursue a personal passion, but only brings in an average salary of $45,000. The other option is a job that doesn’t make you excited to get out of bed every morning but comes with an average starting salary of $75,000.
Say you choose the field you’re more enthusiastic about. The opportunity cost is the extra income you could have earned with the higher paying job. In this case, it equals the extra $30,000 you could have banked every year had you taken the bigger salary.
Imagine a balancing scale...
On one side of the scale is the benefit of choosing Option A. On the other side is the benefit of choosing Option B.
Every choice comes with some kind of trade-off — aka opportunity cost. It’s important to factor that cost into your decision-making process to avoid major losses.
Not only can you use opportunity cost to make personal decisions, but it’s also used by companies to make business decisions. It’s not reported to investors on an income statement or balance sheet, but it can have major repercussions on the future success of a business.
In reality, opportunity cost is an important concept for individuals, investors, and businesses alike. It’s relevant in microeconomics, business environments, as well as in your personal life. Opportunity cost requires you to think long-term
It’s easy to only consider the opportunity cost incurred today when making a financial decision. But to really weigh opportunity costs, start thinking long-term as well.
When considering two potential investments, you might gravitate towards the one that is more likely to earn more money in the next year or two. But long-term growth often requires decisions that don’t see greater profits until years into the future.
Calculating opportunity cost may reveal the potential for long-term growth over the allure of a quick win. It also helps analyze the benefits and drawbacks of borrowing money, whether through a business loan or consumer debt.
Opportunity cost uncovers the loss of not making a decision
Opportunity cost also exists when you make no choice at all.
Imagine you’re considering either investing in the stock market or investing in home renovations to increase the value of your house. Instead of choosing, you decide to keep the money and store that cash in a savings account.
The opportunity cost in this scenario is the return you could have seen on either one of those investments. The same is true for a company that chooses not to reinvest its earnings back into the business.
Debt refers to the borrowed money being used in the business. Equity refers to contributed capital in the form of investments.
Businesses have to weigh the pros and cons of the two options and determine the ideal capital structure for their company. There are several trade-offs to consider.
Taking out a business loan, for example, comes with pros and cons. The injection of capital could potentially fuel the company’s growth and also result in additional tax deductions on the interest payments. However, a loan ties up capital throughout the repayment process. Investing the funds used for the loan payments could result in higher returns than the business expansion.
All companies have to determine their ideal capital structure. Some businesses aim for the lowest weighted average cost of capital (WACC). The optimal capital structure also varies by industry. Industries with less predictable cash flow might be less inclined to take on debt.
Sunk cost refers to money the company has spent and can’t recover. The critical difference between a sunk cost and an opportunity cost is that the sunk cost refers to money that the company actually had at one point. The opportunity cost, on the other hand, is hypothetical money the company could have had if it made a different choice.
Let’s say you spent $1,000 on a piece of equipment for your company. Once the transaction is complete, that $1,000 is a sunk cost.
However, instead of spending that money on equipment, you could have invested it in the stock market. The capital gains return you could have earned is your opportunity cost.
In business, risk is the possibility that a return on investment won’t be as significant as you thought.
Risk refers to the possibility that capital gains returns turn out lower than expected. It also includes the possibility of losing your initial investment.
The key difference between risk and opportunity cost is that risk involves an actual amount of money you could lose. Opportunity cost, on the other hand, refers to a theoretical amount of money that you might have gained or lost had you made an investment.
Let’s consider a real-world example. You decide to invest in the stock market. In a best-case scenario, your initial investment grows over time. However, there’s also the risk that you might lose everything (or simply not earn anything additional).
Now, let’s say you decide not to invest after all. But the market does well, and your investment would have earned you $1,000. That potential $1,000 represents your opportunity cost in this example.
It is often the case (though not always) that the investment with the most significant risk is also the one with the greatest potential opportunity cost.
Not every opportunity cost is quantifiable. Choosing a job that pays more money versus a lower-paying job that allows you to spend more time with your family impacts your quality of life as well as your bottom line.
But in business and investing, you can calculate opportunity costs by finding the difference between the returns of each option you’re considering. Figure out how to calculate opportunity cost using this formula:
Opportunity Cost = Return on Best Foregone Option - Return on Chosen Option
Say you’re debating whether to invest in the stock market. The potential return would be the capital gains on your initial investment over time.
But you could also experience a return on investing your money in something else, like home renovations. Your return in this scenario would be the increased value of your home.
If you decide to invest that money in the stock market (your chosen option) rather than home improvements (the best foregone option), the formula for the opportunity cost looks like this:
Opportunity Cost = Increased Home Value - Capital Gains Returns
There’s no guarantee that you’ll actually get your projected returns, but calculating the opportunity cost for a number of scenarios helps you in the decision-making process.
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