An opportunity cost is the value of money you lose when choosing between multiple options. When you decide, you pick the option that will have better results regardless of what you will lose. For investors, opportunity cost means investment choices will always have immediate and future losses or gains. There are two types of opportunity costs (implicit and explicit). There are various advantages and disadvantages to opportunity cost varying from awareness of losses, knowing the relative price, and time investment. Every choice has trade-offs, so opportunity cost helps you see the potential benefits you will miss out on depending on which direction you choose.
What is Opportunity Cost?
Opportunity cost is the profit that an individual, investor, or business misses out on since they choose one alternative over another. Since opportunity costs are often unseen, they can be easily overlooked. To properly weigh opportunity costs, the costs and benefits of every option available must be considered and weighed against others. When people ponder the value of an opportunity cost, they can make more profitable decision-making. Also, opportunity cost does not always involve money and can refer to alternative uses of time. For instance, do you spend 20 hours learning a new skill or 20 hours reading a book?
What is the Importance of Opportunity Cost?
Understanding the role opportunity cost plays helps you make better decisions. Once you fully grasp each option’s potential cost and benefits, you can make more informed decisions and be prepared for any possible consequences. Opportunity cost involves picking the cost of the next best alternative deeming it more rewarding. Remember that if no options are available, there is no opportunity cost. Also, the available options should have some kind of value associated with them.
What is an Example of Opportunity Cost?
Suppose an investor has been encouraged since 18 to always put 100% of their disposable income into bonds with their parents. For the next 50 years, this investor regularly invested $5,000 per year in bonds, achieving an average annual return of 2.50% and retiring with a portfolio worth nearly $500,000. While this result may seem stellar, it is less impressive considering the opportunity cost. If the individual had invested half of their money in the stock market and received an average blended return of 5%, their retirement portfolio would be worth more than $1 million. That is why it is crucial to consider opportunity costs.
What are the Key Factors of Opportunity Cost?
When investing time, money, and effort, people have to look for the option with the highest possible return on investment. Therefore, they must give up the value they would have yielded from the second-best alternative. Monetary value, time, and energy are key factors of opportunity cost. The monetary value for any opportunity must offer an adequate return to the investor. Time cannot be reversed once it is invested. The benefit a certain opportunity provides over a period must be the highest compared to other alternatives. Additionally, the energy put towards the alternative is essential and requires lots of skills and evaluation.
What are the Types of Opportunity Costs?
Opportunity cost is inextricably linked with the idea that every decision requires a trade-off. The most important thing to note is the presence and availability of options so that you can make decisions. If no options are present, then there is no opportunity cost. The option can be a product or service and involve making production or investment decisions.
When looking at opportunity costs, investors usually examine two types: explicit and implicit.
|Explicit costs are direct, out-of-pocket payments such as purchasing a stock or option or spending money to enhance the rental property. Costs can consist of wages, utilities, materials, or rent. For example, suppose you own a restaurant and add a new menu item that requires $30 in labor, ingredients, electricity, and water. In that case, your explicit cost is $30. The opportunity cost is what you could have done with the $30 had you not added a new item to the menu. Other benefits could be giving the money to charity, buying new clothes, or placing it in your retirement fund and letting it earn interest for you.
|Implicit costs do not represent financial payments. They are not direct costs and display the lost opportunity to generate income through your resources. Suppose you have a second house you are using as a vacation home. In that case, the implicit cost is the rental income you could have acquired if you leased it and collected monthly rental checks when you are not using it. It does not cost you anything upfront to use the vacation home. Still, you are giving up the opportunity to generate income from the property if you choose not to lease it.
1. Explicit Cost
Explicit costs apply when someone takes a specific course of action. They can be fixed or variable, but they must be a clear amount. They are what firms directly pay for, which can be viewed on accounting sheets. Explicit opportunity costs include wages, materials, stock purchases, rent, utilities, and other tangible expenses. Any dollar amount required to proceed with a choice falls under explicit costs.
2. Implicit Cost
Implicit costs are not always incurred by a specific action, and they are indirect and can be difficult to identify. They still affect companies but do not always appear on balance sheets. Implicit costs represent income or other benefits you could have generated if you had made the alternative choice. Basically, by choosing one route, there is the possibility of missing out on something else that is beneficial.
How Does Opportunity Cost Work?
Implicit costs do not represent financial payments. They are not direct costs and display the lost opportunity to generate income through your resources. Suppose you have a second house you are using as a vacation home. In that case, the implicit cost is the rental income you could have acquired if you leased it and collected monthly rental checks when you are not using it. It does not cost you anything upfront to use the vacation home. Still, you are giving up the opportunity to generate income from the property if you choose not to lease it.
What is the Formula for Opportunity Cost?
The formula for opportunity cost is Opportunity Cost = FO – CO. FO equals a return on the best-forgone option, and CO equals a return on the chosen option. Calculating the opportunity cost simply involves computing the difference between the expected returns of each option. For instance, the stock market’s expected return on investment (ROI) is 12% over the next year, and your company expects the equipment update to generate a 10% return over the same period. The opportunity cost of choosing the equipment over the stock market is 2% (12% – 10%). Basically, investing in the business will cause the company to forgo the opportunity to earn a higher return.
How to Calculate Opportunity Cost?
The opportunity cost equation is important for individuals to make well-informed decisions. The equation requires you to calculate the returns of various investment choices and determine what will be lost by choosing one alternative over another.
Follow the steps below to calculate opportunity cost.
- Consider the ratio of what you are sacrificing to what you are gaining.
- Make a choice between two options. For example, you may choose between two jobs (mechanic or bartender). As a mechanic, you could earn $50 per hour. But as a bartender, you could be making around $25 per hour, even with tips.
- Weigh the opportunity cost. Consider your gains and losses before settling on a final decision.
Where are Opportunity Costs Recorded?
Opportunity costs are not recorded on a company’s financial statements. They are only considered in decision-making, so they do not need to be documented. The opportunity cost is the amount of money or benefits lost or given up when choosing one alternative over another. You have to weigh potential outcomes against others. There is a computation on the returns of two investments, and the difference is evaluated based on which to choose.
How Individual Decisions are Influenced by Opportunity Cost?
Opportunity cost can be used for deciding on various things. Some examples are whether to go on vacation now or wait, go to college now in hopes of generating a large return several years in the future or pay down debt. It works best in situations where there is a common unit of measure (money spent or time used). It is strictly a financial analysis concept, so it does not appear in any books or statements. Opportunity cost is solely available to guide individuals in decision-making processes.
What are the Benefits of Opportunity Cost?
Opportunity costs are the financial or non-financial benefits you give up when you choose one option over another. Whether it is a personal or business reason, opportunity cost exists because you believe one option has better benefits than another.
Listed below are some benefits of opportunity cost.
- Assist in Making Better Decisions: Weighing opportunity costs enables you to make the best decisions regarding your business operations.
- Determine a Relatively Profitable Opportunity: After examining your options, you can make the best possible choice moving forward.
- Avoid Humiliation During Project Implementation: By weighing your choices, you avoid making careless mistakes and wasting time on methods or plans that will provide no valuable solution.
1. Assists in Making Better Decisions
You can consider the possibility that you are giving up something when selecting options. If you go to a grocery store seeking meat and cheese but only have money for one, you have to weigh the opportunity cost of what not to buy. When you acknowledge this, you can maximize resources and make better decisions.
2. Determine a Relatively Profitable Opportunity
Another benefit is comparing the relative prices and benefits of each alternative. Compare the total value of each option and decide which offers the best value for your money. Suppose a business with an equipment budget of $100,000 buys ten pieces of equipment A at $10,000 or 20 pieces of Equipment B at $5,000. In that case, you could purchase some of A and B, but relative pricing means comparing the value to you of 10 pieces of A versus 20 pieces of B.
3. Avoid Humiliation during Project Implementation
There are various benefits and consequences relating to opportunity cost. It is best to ensure you have all or most of the information you need to make proper decisions. Depending on your choice, you may reap more losses than gains. To avoid humiliation during project implementation, always thoroughly weigh the pros and cons of each alternative.
What are the Limitations of Opportunity Cost?
Like with everything, some limitations come with opportunity costs. That does not mean you should not utilize this financial method. It just means that errors can occur, and sometimes you may find that you invested more than you should have.
Below are a few limitations of opportunity cost.
- Time Consuming: You can spend multiple hours figuring out the best option to choose for whatever your needs are. And you may have to map out numerous plans to determine which one to choose.
- Unproductive: It is highly beneficial to weigh each decision’s pros and cons. This helps eliminate wasted time and effort spent on useless things.
- Subjective: Everyone operates differently, so what suits one person may not fit someone else. Always keep this in mind when considering opportunity costs. This will help you avoid getting lost in what you believe other people would decide or how they may view your decision.
Opportunity cost takes time to compute and consider. You can make better decisions by pondering opportunity costs, but managers have limited time to compare options and make business decisions sometimes. Similar to how customers going to grocery stores with lists and contemplating the potential opportunity costs of every item is draining. Sometimes you have to make instinctive decisions and evaluate results later.
If you do not adequately weigh the benefits and limitations, you risk wasting time and making uninformed, risky decisions. By considering opportunity costs, you can ensure that you make well-informed choices and view all of the alternatives presented to you.
The advantages of alternatives vary for each person. What one person views as worth investing in, another may view it as a potential risk and choose a different alternative. Remember that opportunity costs differ for each person. What works for one individual may not work for another.
How does Opportunity cost Benefit the Government?
Opportunity cost benefits the government by assisting them in using resources wisely. The government handles confidential data and other things and must ensure they are making the best decisions for the nation. By considering the opportunity cost of resources used to produce goods supplied through the public sector. If the government did not use these resources, then they could be used by people and firms in the private sector. However, the government should be aware of where resources are going.