The comparison of one economic option to the next best one is known as opportunity cost. When deciding between investment possibilities, these comparisons are common in finance and economics. The opportunity cost is a way of evaluating the financial effect of choosing one investment over another. Here’s how to calculate opportunity cost, as well as some examples of how you may utilize it to make better financial decisions.
What Is the Meaning of Opportunity Cost?
Investors are constantly faced with decisions regarding where to put their money in order to get the best or safest return. The expense of a foregone option is represented by the investor’s opportunity cost. When you pick one option over another, the price you pay for that option becomes your opportunity cost.
Not only do individuals consider opportunity costs when making decisions, but many corporations do as well. When it comes to production, time management, and capital allocation, businesses will consider opportunity costs.
Opportunity costs can be thought of as a trade-off. Any decision that necessitates foregoing one option in favor of another involves trade-offs. So, if you choose to invest in government bonds rather than high-risk equities, you’re making a trade-off. The term “opportunity cost” is used to try to put a monetary value on a trade-off.
What is the formula for calculating opportunity cost?
The opportunity cost is calculated by comparing the rewards of two possibilities. This may be done by predicting future returns throughout the decision-making process. Alternatively, you may assess the opportunity cost in retrospect by comparing returns since the choice was taken. The formula below shows how to calculate opportunity costs:
How Opportunity Cost Is Calculated
When making decisions, investors strive to consider the prospective opportunity cost, but the assessment of opportunity cost is considerably more accurate with hindsight. It’s simpler to compare the return of a selected investment to the foregone option when you have real data to work with rather than guesses.
Consider the situation when your aunt must choose between buying stock in Company ABC and Company XYZ. She decides to purchase ABC. ABC has returned 3% year after year, whereas XYZ has returned 8% year after year. She can calculate her opportunity cost as 5% in this situation (8 percent – 3 percent ).
Investors frequently use opportunity cost to assess assets, but the notion may be used in a variety of contexts. The opportunity cost of your friend’s decision to stop employment for a year to go back to school, for example, is the year’s worth of missed income. Your acquaintance will weigh the benefits of a higher education degree against the potential cost of missed earnings.
Instead of reading another article, checking your Facebook page, or watching television, you decided to read this one. This decision resulted in a compromise. The notion of opportunity cost is that your life is the outcome of your previous decisions.
Opportunity Cost Limitations
The difficulty of precisely estimating future returns is the major restriction of opportunity cost. You can look at past data to have a better understanding of how an investment will perform, but you’ll never be able to forecast an investment’s success with 100% precision.
Opportunity cost is still an important factor to consider when making a decision, but it isn’t accurate until you’ve made your selection and can evaluate how the two investments performed.
While the idea of opportunity cost applies to any action, it becomes more difficult to measure when elements that cannot be quantified are included. Assume you have two investing options. One pays a conservative return but only needs you to put your money down for two years, while the other won’t let you touch your money for ten years but will pay a greater rate of interest with a minor increase in risk. Differences in liquidity will be part of the opportunity cost in this situation.
The largest opportunity cost in terms of liquidity is the risk of missing out on a great investment opportunity in the future because you can’t access your money since it’s locked up in another transaction. That is a genuine potential cost, but it is difficult to define in terms of dollars, therefore it does not neatly fit into the opportunity cost calculation.
Individual Investors: What Does It Mean?
If you’re having problems grasping the concept, keep in mind that opportunity cost is intrinsically tied to the idea that almost every action involves a trade-off. You can’t be in two locations at once since we live on a finite planet.
1. Explicit Costs
Explicit expenses are direct, out-of-pocket expenditures made by investors, such as the purchase of a stock or option, or the expenditure of funds to renovate a rental property. Wages, utilities, supplies, and rent are all examples of costs.
If you run a restaurant and want to add a new dish to the menu that costs $30 in labor, food, energy, and water, your explicit cost is $30.
The amount of money you could have saved if you hadn’t chosen to add the extra item to the menu is your opportunity cost. You might have given $30 to charity, spent it on yourself, or invested it in a retirement account to earn interest.
Costs of using assets you own (explicit) and out-of-pocket costs are examples of explicit and implicit costs (implicit).
2. Implicit Costs
Implicit costs do not imply a monetary exchange. They aren’t a direct expense to you; rather, they represent a missed potential to earn money using your resources.
For example, if you have a second property that you use as a holiday home, the implicit cost is the rental revenue you might have made if you leased it and got monthly rental checks while you weren’t using it. You won’t have to pay anything to use the vacation house yourself, but if you don’t lease it, you’ll miss out on the possibility to earn money.
Examples of Opportunity Costs
Example 1: Example of a Real-Life Opportunity Cost
Another example of Opportunity Cost in our daily lives is the decision to choose one alternative over another. In this scenario, the cost of foregoing an option is called Opportunity Cost. Let’s have a look at an example:
Mr. Andrews consults with clients on legal issues and charges a $500 hourly cost. He’s seeking someone to perform typing work for his book, which generally costs $1000 per month. It will take him 3 hours to complete it himself if he chose to do it himself. Mr. Andrews’ opportunity cost is the number of consultancy charges foregone as a result of his decision to do it on his own.
Example 2 – Example of a Real-Life Opportunity Cost
Celeste is presently employed in the Audit Division of a prominent Big 4 business, where she earns a salary of $50000 per year. She wants to get her MBA from Wharton, which would cost her $100,000 and require her to leave her job for two years because it is a full-time program. Celeste’s opportunity cost is sacrificing her annual salary of $50000 for two years in order to get her MBA at Wharton.
Example 3 – Tradeoff
Opportunity cost examples can also be seen from the perspective of a tradeoff between the options foregone and the options chosen. Let’s use an example to illustrate the point:
Costa Rica, a developing country, has a national debt of 3000 billion dollars and must pay a 340 billion dollar interest charge on it every year. The Costa Rican government makes a bargain by spending less money on social programs and more on infrastructure development, healthcare, and education, among other things, by making such a contribution. As a result, the amount foregone on social assistance initiatives by the Costa Rican government is the opportunity cost of paying interest payments.
Conclusion – Opportunity Costs
Every action we take in our daily lives has an Opportunity Cost associated with it, as we can see. By choosing to study in our early years of life, we are foregoing enjoyment and leisure time with our families and friends. Similarly, a working woman professional who leaves her career after marriage to care for her new family incurs an opportunity cost of income that she would have earned if she had stayed at her previous employment, and so on. There are countless examples of Opportunity Costs that we face on a daily basis in our job and everyday lives