Opportunity Cost: Definition, Formula, and Examples

how to calculate the opportunity cost

That action might mean hiring a marketing director for $80,000 per year or investing in marketing automation software for $3,000 per month, depending on the opportunity cost. In short, any trade-off you make between decisions can be considered part of an investment’s opportunity cost. To calculate the opportunity cost, subtract the return of the chosen option from the return of the best option.

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how to calculate the opportunity cost

Later, you think that you could have funneled that $1,000 into an ad campaign and won 30 new customers. If you determined the difference in revenue generated by each of those two scenarios, you’d be able to find the opportunity cost. In other words, if the investor chooses Company A, they give up the chance to final accounts definition examples earn a better return under those stock market conditions. Although some investors aim for the safest return, others shoot for the highest payout. Keep in mind that, whether a business owner, accountant, or seasoned investor is running the numbers, there are some limitations when calculating opportunity cost.

Opportunity cost vs. risk

Opportunity cost figures can give you insight into the direction you want to go in and guide your financial decision-making. However, it’s important to note that opportunity cost can aid in deciding between two risk profiles. For example, let’s say you have the option between investment #1, which is rather precarious, but has a possible ROI of 21%, or investment #2, which is considerably less risky, but only has an ROI of 7%. Implicit costs, on the other hand, are costs that are the result of a lost opportunity to use owned resources for wealth generation. For example, implicit cost could be the opportunity cost of spending time training employees instead of spending that time meeting potential clients. Although this formula seems rather simple, it can actually involve complicated calculations.

Opportunity Cost vs. Risk

Truly, there will never be an instance where you can predict the outcome of an investment with 100% accuracy. Therefore, opportunity cost represents the cost of inevitably choosing one option over the other, whereby the measurement becomes the metric you can use to make a decision. With that in mind, this article will serve as a guide to understanding opportunity cost by explaining how it’s calculated and why it can be beneficial, as well as providing real-life examples of its use. A hard truth in economics is the concept of scarcity, the idea that there is a limited supply of resources, time, and money. Because of scarcity, one cannot have everything one wants, but choices have to be made at the expense of other possible choices. The opportunity cost of selecting the software company stock as an investment vehicle is 2%.

Assume that a business has $20,000 in available funds and must choose between investing the money in securities, which it expects to return 10% a year, or using it to purchase new machinery. No matter which option the business chooses, the potential profit that it gives up by not investing in the other option is the opportunity cost. Companies try to weigh the costs and benefits of borrowing money vs. issuing stock, including both monetary and non-monetary considerations, to arrive at an optimal balance that minimizes opportunity costs. Because opportunity cost is a forward-looking consideration, the actual rate of return (RoR) for both options is unknown at that point, making this evaluation tricky in practice. There’s no doubt that investing can be a nerve-wracking and tricky business. However, with the right precautions, it can also be extremely profitable.

Business leaders must often make decisions in light of opportunity cost, including in the context of determining optimal capital structure. Investing in securities products involves risk and you could lose money. Brex Treasury is not a bank nor an investment adviser and your Brex business account is not an FDIC-insured bank account. Whether it’s an investment that didn’t go to plan or marketing software that didn’t improve lead quality, no one likes to see money disappear. Next, let’s look at the opportunity cost formula to see how entrepreneurs analyze each trade-off.

In business-oriented situations, understanding opportunity can also allow you to make intelligent investments, even if differences are marginal. Over time, more thoughtful decision-making will help your business grow. For instance, if you’re currently thinking of buying a new car, you can use opportunity cost to identify the pros and cons of possible purchases. Maybe you want an inexpensive sedan, but there’s admittedly more value in a larger SUV. An opportunity cost calculation could help you navigate your decision-making, as there will undoubtedly be sacrifices to make either way. Opportunity cost is a valuable financial tool you can use to understand the benefits and downsides of choosing one investment option over the other, thus allowing you to plan for the future.

It makes intuitive sense that Charlie can buy only a limited number of bus tickets and burgers with a limited budget. Any effort to predict opportunity cost must rely heavily on estimates and assumptions. There’s no way of knowing exactly how a different course of action will play out financially over time. Investors might use the historic returns on various types of investments in an attempt to forecast their likely returns. However, as the famous disclaimer goes, “Past performance is no guarantee of future results.”

  1. Over time, more thoughtful decision-making will help your business grow.
  2. Opportunity cost reflects the possibility that the returns of a chosen investment will be lower than the returns of a forgone investment.
  3. 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.
  4. What does opportunity cost have to do with a business’s capital structure?
  5. So the opportunity cost of changing fields may include more tuition and training time, but also the cost of the job this is left behind (as well as the potential salary of a job in the new field).

Lilith has some important business decisions to make concerning the allocation of her company’s resources over the next fiscal year. A large part of her decision-making analysis will concern calculating and assessing opportunity cost. In each of the above examples, there are decisions that must be made as not every path can be simultaneously taken. Although many applications of opportunity cost are in the context of business, the concept is extremely useful for personal finance and even other personal life choices. When you have limited time, money, and resources, every business decision comes with an opportunity cost. Learning how to calculate opportunity cost is an essential skill for all business owners.

Opportunity cost can be applied to any situation where you need to make a choice between two or more alternatives. 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. If we want to answer the question, “how many burgers and bus tickets can Charlie buy? 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.

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