What Is Opportunity Cost
Opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another. While financial reports do not show opportunity cost, business owners can use it to make educated decisions when they have multiple options before them. Because by definition they are unseen, opportunity costs can be easily overlooked if one is not careful. Understanding the potential missed opportunities foregone by choosing one investment over another allows for better decision-making.
How to Calculate Opportunity Cost
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. Option B is to reinvest your money back into a 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 percent over the next year, and your company expects the equipment update to generate a 10 percent 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 the higher return.
Opportunity cost analysis also plays a crucial role in determining a business’s capital structure. While both debt and equity require expense to compensate lenders and shareholders for the risk of investment, each also carries an opportunity cost. Funds used to make payments on loans, for example, are not being 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.
Because opportunity cost is a forward-looking calculation, the actual rate of return for both options is unknown. Assume the company in the above example foregoes new equipment and invests in the stock market instead. If the selected securities decrease in value, the company could end up losing money rather than enjoying the expected 12 percent return.
For the sake of simplicity, assume the investment yields a return of 0%, meaning the company gets out exactly what it put in. The opportunity cost of choosing this option is 10% – 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 percent, the T-bill is the safer bet when you consider the relative risk of each investment.
What Does Opportunity Cost Tell You?
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 for an investment vehicle. However, businesses must also consider the opportunity cost of each option. Assume that, given a set amount of money for investment, a business must choose between investing funds in securities or using it to purchase new equipment. No matter which option the business chooses, the potential profit it gives up by not investing in the other option is the opportunity cost.
Example of How to Use Opportunity Cost
When 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. If they’re cautious about a purchase, many people just look at their savings account and check their balance before spending money. Often, people don’t think about the things they must give up when they make those decisions.
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 true 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. Even clipping coupons versus going to the supermarket empty-handed is an example of an opportunity cost unless the time used to clip coupons is better spent working in a more profitable venture than the savings promised by the coupons. Opportunity costs are everywhere and occur with every decision made, big or small.
The Difference Between Opportunity Cost and a Sunk Cost
The difference between an opportunity cost and a sunk cost is the difference between money already spent and potential returns not earned 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 make an investment, and getting that money back requires liquidating stock at or above the purchase price. 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 buy a piece of heavy equipment with an expected return on investment (ROI) of 5% or one with an ROI of 4%.
Again, an opportunity cost describes the returns that one could have earned if he or she invested the money 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 rose in value from $10 a share to $15. In this scenario, investing $10,000 in company A netted a yield of $2,000, while the same amount invested in company B would have netted $5,000. The $3,000 difference is the opportunity cost of choosing company A over company B.
As an investor that has already sunk money into investments, you might find another investment that promises greater returns. The opportunity cost of holding the under performing asset may rise to where the rational investment option is to sell and invest in the more promising investment.
The Difference Between Risk and Opportunity Cost
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 a different 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.