Opportunity Cost Explained: Insights for Informed Decisions

how to compute the opportunity cost

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You’d also face an opportunity cost with your vacation days at work. If you use some of them now with your spare $1,000 you won’t have them next year (assuming your employer lets you roll them over from year to year). Pete Rathburn is a copy editor and fact-checker with expertise in economics and personal finance and over twenty years of experience in the classroom. Our writers and editors used an in-house natural language generation platform to assist with portions of this article, allowing them to focus on adding information that is uniquely helpful. The article was reviewed, fact-checked and edited by our editorial staff prior to publication. Take your learning and productivity to the next level with our Premium Templates.

  1. Opportunity cost is the comparison of one economic choice to the next best choice.
  2. Knowing how to calculate opportunity cost can help you accurately weigh the risks and rewards of each option and factor in the potential long-term costs of doing so.
  3. Opportunity cost is the cost of what is given up when choosing one thing over another.
  4. The opportunity cost of choosing to invest in Company A versus Company B is 10% minus 6%.
  5. Your alternative is to keep using your current vehicle for the next two years, and invest money with a 3 % rate of return.

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As such, it is important that this cost is ignored in the decision-making process. Say a shoe manufacturer has the option of investing in new equipment that is expected to provide a return of roughly 9% the first year. Alternatively, the company can put its money into securities that generate income of 3% a year. In economics, risk describes the possibility that an investment’s actual and projected returns will be different and that the investor may lose some or all of their capital. Opportunity cost reflects the possibility that the returns of a chosen investment will be lower than the returns of a forgone investment.

Example of an Opportunity Cost Analysis for a Business

For example, a person could spend $12 watching a matinee movie, or they could use it to buy lunch. If they opt for the former, they may not have money for the latter, and vice versa. On the other hand, “implicit costs may or may not have been incurred by forgoing a specific action,” says Castaneda. “Explicit costs are those that are incurred when taking a specific course of action,” says Bob Castaneda, program director of Walden University’s College of Management of Technology. Opportunity costs can be easily overlooked because sometimes the benefits are unrealized, and therefore, hidden from view.

Trade-offs take place in any decision that requires forgoing one option for another. So, if you chose to invest in government bonds over high-risk stocks, there’s a trade-off in the decision that you chose. Opportunity cost attempts to assign a specific figure to that trade-off. If you are wondering how to calculate opportunity cost, check the sections below to find its formula and some more examples. Opportunity cost is a term that refers to the potential reward that you forgo when choosing one option over the next-best alternative. Any effort to predict opportunity cost must rely heavily on estimates and assumptions.

The opportunity cost attempts to quantify the impact of choosing one investment over another. Your alternative is to keep using your current vehicle for the next two years, and invest money with a 3 % rate of return. There is a 22 % tax on capital gains, and the inflation rate is 1.5 %. Your interest is compounded monthly – that means your earned interest will be added to your account each month, and next month your interest will be calculated on that new, larger amount.

how to compute the opportunity cost

Let’s say professional painters would have charged Larry $1,000 for the work. An investor calculates the opportunity cost by comparing the returns of two options. This can be done during the decision-making process by estimating future returns. Alternatively, the opportunity cost can be calculated with hindsight by comparing returns since the decision was made. Opportunity cost is the comparison of one economic choice to the next best choice. These comparisons often arise in finance and economics when trying to decide between investment options.

Ultimately, Tiller says, “considering the opportunity cost will help show the most profitable option to invest in, making the decision-making process easier for you.” Any time an individual makes a purchase now, he is doing so at the expense of future consumption or savings. In other words, any time someone buys an item in the present, https://www.kelleysbookkeeping.com/ he is giving something up in the future. For example, if someone spends $20 on lunch every day at work instead of packing their own lunch using $5 worth of groceries, they are losing $15 every day through this decision-making. Alternatively, if the business purchases a new machine, it will be able to increase its production.

In simplified terms, it is the cost of what else one could have chosen to do. If we plot each point on a graph, we can see a line that shows us the number of burgers Charlie can buy depending on how many bus tickets he wants to purchase in a given week. If you plug other numbers of bus tickets into the equation, you get the results shown in Table 1, below, which are the points on Charlie’s budget constraint. Now we have an equation that helps us calculate the number of burgers Charlie can buy depending on how many bus tickets he wants to purchase in a given week.

You may also find it useful to go through an opportunity cost example, which provides you with a step-by-step model you can adjust to your own needs. The decision in this situation would be to continue production the historical cost principle requires that when assets are acquired as the $50 billion in expected revenue is still greater than the $40 billion received from selling the land. The $30 billion initial investment has already been made and will not be altered in either choice.

Money that a company uses to make payments on its bonds or other debt, for example, cannot be invested for other purposes. So the company must decide if an expansion or other growth opportunity made possible by borrowing would generate greater profits than it could make through outside investments. While opportunity costs can’t be predicted with total certainty, taking them into consideration can lead to better decision making. To go deeper into opportunity cost calculation, use the advanced mode, and follow the formulas below. Keep reading to find more about the assumptions this tool uses, how to calculate opportunity cost, and the opportunity cost definition.

If we want to answer the question, “how many burgers and bus tickets can Charlie buy? You can calculate opportunity cost by subtracting the return on the chosen option from the return on the option passed up. For example, the money you’ve already spent on rent for your office space is a sunk cost. But the funds you haven’t spent on office furniture yet would be considered an opportunity cost because you haven’t actually spent the money yet. Opportunity costs matter to investors because they are constantly selecting the best option among investments. The opportunity cost of choosing to invest in Company A versus Company B is 10% minus 6%.

Consider a young investor who decides to put $5,000 into bonds each year and dutifully does so for 50 years. Assuming an average annual return of 2.5%, their portfolio at the end of that time would be worth nearly $500,000. Although this result might seem impressive, it is less so when you consider the investor’s opportunity cost. If, for example, https://www.kelleysbookkeeping.com/reasonable-salaries-and-s-corps/ they had instead invested half of their money in the stock market and received an average blended return of 5% a year, their portfolio would have been worth more than $1 million. Take, for example, two similarly risky funds available for you to invest in. The opportunity cost of the 10 percent return is forgoing the 8 percent return.

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