Opportunity cost represents the potential benefits that a business, an investor, or an individual consumer misses out on when choosing one alternative over another.
While opportunity costs can’t be predicted with total certainty, taking them into consideration can lead to better decision-making.
Key Takeaways
- Opportunity cost is the forgone benefit that would have been derived from an option other than the one chosen.
- To properly evaluate opportunity costs, the costs and benefits of every option available must be considered and weighed against the others.
- Considering potential opportunity costs can guide individuals and organizations to more profitable decision-making.
- Opportunity cost is a strictly internal measure used for strategic planning; it is not included in accounting profit or reflected in external financial reporting.
- Examples of opportunity cost considerations include investing in a new manufacturing plant in Los Angeles or Mexico City, deciding to upgrade company equipment or hire additional workers, or buying Stock A vs. Stock B.
Formula for Calculating Opportunity Cost
We can express opportunity cost in terms of a return (or profit) on investment with this formula:
$$ Opportunity Cost = RMPIC - RICP $$
where:
- RMPIC = Return on the most profitable investment choice
- RICP = Return on the investment chosen to pursue
Example Calculation
Consider a company faced with two mutually exclusive options:
Option A: Invest excess capital in the stock market
Option B: Invest excess capital back into the business for new equipment to increase production
Assume the expected return on investment (ROI) in the stock market is 10% over the next year, while the business expects that the equipment update would generate an 8% return over the same period. The opportunity cost of choosing the equipment over the stock market is 2% (10% - 8%).
When considering two different securities, it’s important to take risk into account. For example, comparing a Treasury bill to a highly volatile stock can be misleading, even if both have the same expected return.
Opportunity Cost and Capital Structure
Opportunity cost analysis plays a crucial role in determining a company’s capital structure. Businesses incur an explicit cost in taking on debt or issuing equity, which carries an opportunity cost: money used to make debt payments cannot be invested elsewhere.
Companies aim to balance borrowing costs vs. issuing stock to minimize opportunity costs, a forward-looking consideration making this evaluation tricky in practice.
Example of an Opportunity Cost Analysis for a Business
Assume a business has $20,000 in available funds and must choose between investing in securities, projected to return 10% a year, or purchasing new machinery:
- Securities Option: Gain $2,000 in first year, $2,200 in second year, and $2,420 in third year.
- Machinery Option: Net $500 in profit first year, $2,000 in year two, and $5,000 in all future years.
Choosing securities makes sense for the first two years, but by the third year, the opportunity cost indicates that the new machine is better.
A Dramatic Example: The Most Expensive Pizza Ever?
In 2010, 10,000 bitcoins valued at $41 were traded for two pizzas. As of March 2024, those bitcoins would be worth over $700 million.
Example of an Opportunity Cost Analysis for an Individual
Individuals also face decisions involving opportunity costs. For instance, receiving a $1,000 work bonus could be spent on a vacation now, or invested for a future trip:
- Invest $1,000 in a one-year certificate of deposit (CD) at 5%, yielding $1,050 in a year.
- Consider using vacation days now vs. preserving them for a future trip.
There’s no right or wrong answer, but thinking through opportunity costs helps make more informed decisions.
Opportunity Cost vs. Sunk Cost
A sunk cost is money already spent, whereas opportunity cost refers to potential future returns not earned because the money was invested elsewhere. When considering opportunity cost, ignore sunk costs.
Opportunity Cost vs. Risk
Risk captures the possibility of different outcomes from an investment, including loss, while opportunity cost reflects potential returns of a chosen investment vs. an unchosen one. The key difference is that risk compares actual performance against projected performance, while opportunity cost compares projected performances of different investments.
Accounting Profit vs. Economic Profit
- Accounting profit: Net income calculation often following the generally accepted accounting principles (GAAP).
- Economic profit: Includes opportunity cost as an expense and helps compare actual profit against potential profit from other choices.
Economic profit is an internal value for strategic decision-making.
Simple Definition of Opportunity Cost
Opportunity cost refers to the hidden cost associated with not taking an alternative course of action.
Example of Opportunity Cost in Investing
Consider a young investor who puts $5,000 into bonds yearly for 50 years. Assuming a 2.5% annual return, they would end up with nearly $500,000. If they had invested half in stocks averaging 5% annual return, their portfolio would be worth over $1 million. The opportunity cost is over $500,000.
How Do You Predict Opportunity Cost?
Estimating opportunity cost relies on assumptions and historic returns, accepting that past performance does not guarantee future results.
The Bottom Line
While opportunity costs can’t be predicted with complete certainty, they provide a framework for better decision-making by evaluating investment options.
Related Terms: Sunk cost, Risk, Accounting profit, Economic profit, Capital structure.
References
- Bitcoin Forum. “Pizza for Bitcoins?”
- Coinbase. “BTC/USD: Convert Bitcoin (BTC) to United States Dollar (USD)”.
- Harvard Business School Online. “How Understanding Sunk Costs Can Help Your Everyday Decision Making Processes”.
- U.S. Securities and Exchange Commission. “Investor Bulletin: Performance Claims”.
