Opportunity Cost - Explained
What is Opportunity Cost?
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Table of ContentsWhat is Opportunity Cost?How is Opportunity Cost Used?Formula for Calculating Opportunity CostUsing Opportunity Costs in Our Daily LivesWhat is the Difference Between a Sunk Cost and an Opportunity Cost?What is the Difference Between Risk and Opportunity Cost?Academic Research on Opportunity Cost
What is Opportunity Cost?
Opportunity costs show the advantages an individual, business or investor misses out on when selecting one option over another. While the financial reports don't reveal the opportunity cost, business owners use it to make informed decisions when having various options before them. Since they are not tangible by definition, opportunity costs are often overlooked. By recognizing the potential missed chances and opportunities by selecting one investment over another, one can make better decisions.
How is Opportunity Cost Used?
When evaluating the potential profitability of different investments, companies look for the option that is expected to give the highest return. Often, they know this by determining the expected rate of return for the investment vehicle. However, companies should also think of the opportunity cost of all options. Lets say, given a definite sum of money for investment, a company must select between investing funds in the securities or utilizing it to purchase new equipment. Irrespective of the option the company selects, the potential profit it forgoes by not investing in another option is its opportunity cost.
Formula for Calculating Opportunity Cost
The opportunity cost formula is the difference between the expected returns of all options: Opportunity cost = return of most profitable option not selected - return of chosen option Let's say option A in the example stated above is to invest in a stock market with an anticipation to produce capital gains returns. Option B is to reinvest its money back into the business hoping that newer equipment would result in production efficiency, which eventually lead to higher profit margin and lower operational expenses. Now lets say that the expected return on investment within a stock market is 12% within the next year, and the company estimates the equipment update to produce 10 percent return in the same period. The opportunity cost of selecting the equipment and not the stock market is (12 percent - 10 percent), which is equivalent to 2% points. In simpler words, by making investment in the business, they give up the opportunity to get the higher return. Opportunity cost evaluation also plays a vital role in recognizing a business's capital structure. While both equity and debt need expense to compensate the shareholders and lenders for the risk of investment, each of these also bears an opportunity cost. Funds allocated to the payments on debts, for instance, are not being invested in bonds or stocks, which provide the highest potential for the investment income. The company should make a decision if the expansion is done, then leveraging the debt will lead to more profits than it could make from investments. Since opportunity cost is a forward-looking calculation, we will not know the the actual rate of return for both options. Lets say that the company in the example stated above gives up new equipment and rather invests in the stock market. If the chosen securities decline in value, the company would be losing money instead of having an expected 12 percent return. For simplicity, lets say that investment gives a return of 0 percent, implying that the company gets out exactly what it gave in. The opportunity cost of selecting this option is 10% - 0%, or 10%. It is also possible that, had the company selected the new equipment, there would be no impact on production efficiency, and that profits would stay stable. The opportunity cost of selecting this option will be 12 percent instead of the expected 2 percent. It is essential to compare investment options having similar risk. Comparing a Treasury bill, that is virtually risk-free, to investment in a very volatile stock may lead to a misleading calculation. Both options can have expected returns of 5 percent, but the Government of the United States backs the rate of return of the T-bill, and the stock market doesn't have such guarantee. While the opportunity cost of each option is 0 percent, the T-bill is bit safer if you consider each investments relative risk.
Using Opportunity Costs in Our Daily Lives
When making important decisions such as buying a home or pursuing a startup, you will probably extensively research the whites and blacks of your decision, but most of the day-to-day choices we make aren't made with a complete understanding of the potential opportunity costs. If they're keen about their purchase, most people only consider their savings account and view their balance before putting money into anything. Mostly, we overlook the things we must forgo at the time of making those decisions. However, that type of thinking is dangerous. The problem is that when you never think of what else you can do with your money or purchase things blindly without thinking about the lost opportunities. Going for lunch occasionally is a wise decision, in particular, if it gets you out of the office when the boss is throwing a fit. However, eating a cheeseburger daily for the next 25 years could cause many missed opportunities. Apart from the potential health effects, investing that $4.50 on a cheeseburger will add just over $52,000 within that time frame; i.e. a very doable 5 percent rate of return.
What is the Difference Between a Sunk Cost and an Opportunity Cost?
The difference lies in the difference between the money already spent and possible returns not earned on that investment since one invested capital elsewhere. Purchasing 1,000 shares of company A at the cost of $10 a share, for example, makes a sunk cost of $10,000. This is the sum of money invested and getting that money back needs liquidating stock either above or at the purchase price. A sunk cost may also be termed as the initial outlay to buy an expensive heavy equipment, which can be amortized with time, but which is sunk in the sense that you will not get it back. An opportunity cost is to buy a heavy equipment with a projected return on investment (ROI) of 5% or one with an ROI of 4%. An opportunity cost explains the returns that one could have gained if he or she invested the money in some other instrument. Therefore, while 1,000 shares in the company A might finally sell for $12 a share, bringing a profit of $2,000, during the same period, company B experienced rise in value from $10 a share to $15. In this case, investing $10,000 in company A will yield $2,000, while the same amount put into company B would have yielded $5,000. The $3,000 difference is the opportunity cost of selecting company A over company B.
What is the Difference Between Risk and Opportunity Cost?
In economics, risk is the possibility that an actual and projected returns of the investments are different and that the investor will lose some or all of the invested amount. Opportunity cost raises the possibility that the returns of a selected investment are lower than the returns of a investment not chosen. The major difference is that risk compares the real performance of an investment against the anticipated performance of the same investment, while opportunity cost compares the actual performance of an investment against the actual performance of a different investment.