Opportunity cost, in simple words, is the potential benefit that you are waiving or sacrificing as you choose one thing over its next-best alternative. It is a commonly studied concept of microeconomics that applies to a variety of scenarios in businesses. You may consider the concept of opportunity cost if you are looking at possible investment options, or if you are an employee considering whether overtime is a viable option. It is often possible to ignore and overlook opportunity costs. This is largely due to the fact that most of the benefits are hidden in plain sight and you may not notice them as you make the choice.
How to understand opportunity cost in simple terms?
A fairly simple way to understand opportunity cost is the value we lose by choosing among a number of options. In making the preferred choice, it seems to us that this is the most optimal in terms of the outcomes we will enjoy. From an investor's point of view, opportunity cost implies that investment choices will almost always lead to immediate and proximate gains and losses.
Defining Opportunity Cost with Examples
The definition of opportunity costs is as follows: ‘The loss made when an individual makes a gain, or the loss incurred due to one gain for another one.’
The section below sets out some common examples of opportunity costs.
1. As an investor, you might want to make a choice between selling your stock shares instantly or selling them later. There is a possibility that with the instant sale, you may be able to secure your existing gains. On the other hand, you may be sacrificing any future gains that you might have gotten through that investment in the future.
2. There is no hard and fast rule that says that opportunity cost only applies to monetary issues. It could also be something as simple as choosing between working and skipping work. The opportunity cost is what you lose as you either go or do not go to work for the day.
3. Imagine you run a successful business and are now looking to add a new product to your current product line. The new product requires an initial investment for development and marketing. The opportunity cost, in this case, will be the value of money you would have otherwise spent on something or saved.
The Working of Opportunity Cost
When a financial decision awaits you, it is always convenient to use the concept of opportunity cost. You can simply work out the return that you will make from each alternative. For example, you are somewhat persuaded to sell a bond and invest the money you obtain to buy another one. This opens up new opportunities for you.
There is a possibility that if you choose the current bond, its future value could either go up or down. On the contrary, the future value of the new bond that you are looking to purchase could also go up or down. So, the option that you leave behind as you buy one instead of two is the opportunity cost. It is all about weighing the options available to choose the most suitable choice.
A Step-by-Step Guide to Calculating Opportunity Cost
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It should be noted that you cannot precisely calculate opportunity cost, but rather make an estimate of the likely future value that you decided not to receive and compare it with the value of the choice that you opted for instead.
A general formula for calculating opportunity cost can be as below:
Opportunity Cost = Return on the second-best option that you have forgone – Return on the option that you have chosen.
As you use the formula, you will come to the realization that opportunity cost is a plain, common-sense concept that is explored in-depth by investors and economists. It can be deemed as a proverbial fork in your pathway. There are plenty of dollar signs throughout the pathway, but you will definitely have something to gain and lose as you proceed forward. After all, it all summarizes making informed choices by having realistic estimates of losses for every choice that you make.
Finding Opportunity Costs in Businesses
The most straightforward approach to finding opportunity cost is making an estimate or ratio of what you are sacrificing and what you are gaining in return.
The use of opportunity costs in business is often referred to as economic costs. These are typically used during the process of production. This is linked to ‘not’ choosing a particular opportunity. Most businesses look at the concept as the difference between total revenue and economic profit.
When finding opportunity costs, you may find it useful to understand what is meant by economic profit. This can be explained as the amount of money generated after a business subtracts its implicit and explicit costs. Implicit business costs are abstract in nature and can be explained as the value that could have been produced if business resources had been otherwise utilized for another purpose. Explicit costs may also be referred to as the ‘out-of-pocket’ expenses that the business incurs to run its day-to-day activities.
The concept of implicit and explicit costs (economic costs) might seem to be daunting at first. However, the foundation is that a business streamlines its activities and operations to generate revenues that are higher than its opportunity costs to enjoy cumulative benefits and profits for its owners.
One way to find opportunity costs in a business is to use the concept of a minimum viable product (MVP). By focusing on creating an MVP, a business can minimize its opportunity costs by only investing in the development and marketing of the most essential features, rather than trying to build a fully-featured product from the start. This allows the company to quickly gather data on customer demand and use that information to make informed decisions on what additional features should be considered in the product prioritization process for future developments.
Opportunity Cost and Sunk Cost: What’s the Difference?
It is important to understand the clear differences between sunk costs and opportunity costs. A sunk cost can be explained as one that has already been paid for. An opportunity cost is considered a ‘prospective return’ which you have not received yet. An opportunity cost partakes a forward-looking approach, while a sunk cost is usually backward-looking in nature.
Sunk costs are explicit. They are part of companies' financial statements and clearly indicate where they are incurred. Opportunity costs are invisible and implicit, so companies tend to overlook and ignore them. Because of their seemingly identical nature, confusion prevails about what to consider and what not to consider when making key business decisions. It is important for business owners to recognize and understand the importance and relevance of both types of costs. By making informed business decisions, business savings are more likely to increase and costs are more likely to decrease, ultimately leading to success.
When should you ignore the concept of opportunity costs?
You may be surprised to know that you cannot apply the opportunity cost concept to all situations around you. Sometimes, it is very challenging to derive a qualitative comparison of the two options available. The concept applies most suitably if you are working with a mutual unit of measure between the two alternatives, for example: considering the time or money spent.
Opportunity cost is purely restricted to being a concept of financial analysis. It has no roots in accounting, which is the reason why opportunity costs are not recorded in financial statements.
The Significance of Opportunity Cost for Investors
Opportunity cost is a valuable tool for financial analysis from the investors’ perspective because they are continually seeking the most suitable investment option with the greatest returns. Buying an asset translates to making an informed choice or decision about not buying the other assets.
Being an investor means that you have to weigh out the opportunity cost of every investment decision that you are aiming to proceed with, so as to obtain the most rational and far-sighted decisions. If you do not rely upon the principles of opportunity costs and do not weigh your options correctly, your portfolio may then comprise assets that are outperforming. Developing a carefully constructed portfolio is advantageous as you get guidelines in terms of the percentage of each asset type that you should be holding on to, intending to alleviate the fluctuation or uncertainty of one type of asset. This ultimately decreases the risk part for investors’ decision-making. Instead of scrutinizing every opportunity, the investor now poses a manageable question about the proportion of asset classes he or she should ideally hold.
For investors, it is a wonderful means for gaining a decision-making framework to enjoy the greatest benefits especially when you are working your way with constrained finances and time. While evaluating investment opportunities, it is important to perform a competitive analysis to understand the opportunity cost of choosing one investment over another. This involves examining the potential returns and risks of different investments and comparing them to the alternatives that are available. By analyzing the competition and understanding the opportunity costs of different investment options, investors can make more informed decisions about which investments to pursue. This is especially important when working with limited finances and time, as it can help investors identify investments that offer the best balance between risk and reward.
While we discuss the significance of opportunity costs for investors, we should also be aware that no matter what choice we are making, we will be affected by a certain degree of opportunity cost. No decision comes without the downsides of opportunity costs, particularly when you take into account the inflationary costs.
According to financial advisors and experts, life always comes with limited resources whether you are talking about time, finances, goods, or even services. The trade-off is a mandatory part of life. Opportunity costs, in their true essence, are the means to deciding which trade-offs can you survive with the best.
Frequently Asked Questions
1. What is the opportunity cost and example?
It is the value of what is lost when you make a choice between two or more alternatives. No choice in the world comes without trade-offs. An opportunity cost is a prospective benefit that you have to waive off by preferring one thing over the other.
For example, you have an exam tomorrow and you spend the night watching a movie costing $20. The opportunity cost is the time you were to spend studying, as well as the money you might have spent on something else.
2. What is the opportunity cost simple definition?
This is the loss of other alternatives when you choose one alternative.
3. What is the opportunity cost known as?
It is also referred to as alternative cost.
4. How do you find opportunity cost?
The formula used to calculate opportunity cost is below:
The Return on the Most Profitable Choice of Investment – The Return on the Investment Chosen
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