Concept of Opportunity Cost Explained

Opportunity Cost: What Is It?

Opportunity cost is the value that a company, investor, or individual customer loses out on when selecting one course of action over another.

Even while opportunity costs are impossible to forecast, accounting for them can help you make smarter decisions.

Method for Computing Opportunity Cost

The following formula can be used to express opportunity cost as a return on investment, or profit:

Option Cost = RMPIC - RICP

Where

RMPIC stands for return on the best investment option.
RICP stands for return on investment made.

To compute an opportunity cost, one need only take the difference between the projected returns of all available options. Assume that a business must choose between the following two choices, which are mutually exclusive:

Option A: Put extra money into the stock market

Option B: Reinvest surplus funds to buy new machinery for the company to boost output.

Let us assume that the corporation estimates the equipment update will yield an 8% return over the next year, and that the projected return on investment (ROI) in the stock market is 10%. Selecting the equipment instead of the stock market has a 2% (10% - 8%) opportunity cost. Stated differently, the company would forfeit the chance to obtain a larger return on its investment—at least for the initial year.

Capital Structure and Opportunity Cost

When choosing a company's capital structure, opportunity cost analysis can be quite important. When a company issues equity or takes on debt, it has direct costs associated with it since it has to pay back its investors or lenders. Furthermore, every choice has an opportunity cost.

For example, a firm cannot reinvest money that it uses to pay off bonds or other debt for another use. Therefore, the business needs to determine whether expanding or taking advantage of another growth opportunity made feasible by borrowing would result in higher earnings than it could from outside capital.

Businesses attempt to find the best balance that minimizes opportunity costs by weighing the advantages and disadvantages of borrowing money vs issuing stock, taking into account both monetary and non-monetary factors. The exact rate of return (RoR) for both options is unclear at that point due to opportunity cost being a forward-looking concern, which makes this evaluation challenging in real-world scenarios.

An illustration of an Opportunity Cost Analysis for a Company

Let's say a company has $20,000 in cash on hand. It has to decide whether to invest it in stocks, which should yield a 10% annual return, or use the money toward buying new equipment. The potential profit that the company forfeits by choosing not to invest in the alternative option is known as the opportunity cost, regardless of the choice it selects.

The investment might potentially increase by $2,000 in the first year, $2,200 in the second, and $2,420 in the third if the company chooses the securities option.

Alternatively, the company will be able to boost production if it buys a new equipment. Given that the new machine will not operate at peak efficiency for the first few years due to extensive employee training and machine setup, the company projects that it will make an extra $500 in profit in the first year, $2,000 in the second, and $5,000 in each of the following years.

These estimates indicate that in the first and second years, picking the securities makes sense. The new machine, however, is the better choice after the third year, according to an opportunity cost analysis ($500 + $2,000 + $5,000 - $2,000 - $2,200 - $2,420) = $880.

An Example of an Individual Opportunity Cost Analysis

Opportunity costs are a factor in decisions that people must make, even though they frequently have lower stakes.

Let's say, for instance, that you recently got an unexpected $1,000 bonus at work. You could just spend it right now, on an impromptu trip, or save it for a later excursion. Let's say you invested the whole amount in a secure one-year certificate of deposit at five percent; at this point next year, you would have $1,050 to work with.

Additionally, you would have to forfeit some of your vacation time for work. If you utilize a portion of them now with your extra $1,000, you won't have any left over the following year (if your employer permits you to carry them over).

There is no right or wrong answer in this case, as with many opportunity cost issues, but it can be a useful exercise to consider your options and determine what you value most.

Sunk Cost vs. Opportunity Cost

Money that has already been spent is known as a sunk cost, whereas opportunity cost refers to prospective returns on an investment that are lost because the funds were allocated to other projects. Generally speaking, sunk expenses are disregarded when analyzing opportunity cost.

For example, purchasing 1,000 shares of business A at $10 a share results in a $10,000 sunk cost. This is the investment amount paid out; it cannot be recovered (perhaps not fully even in the event that the stock is sold).

From the standpoint of accounting, a sunk cost can also be the upfront expenditure for a pricey piece of heavy machinery that may be written off over time but is sunk because the business will not be reimbursed for it.

What Does Opportunity Cost in Investing Look Like?

Imagine a youthful investor who chooses to invest $5,000 in bonds annually and does so without fail for 50 years. At the conclusion of that period, their portfolio would be valued close to $500,000. This is based on an average yearly return of 2.5 percent. When you take into account the opportunity cost to the investor, this result, while somewhat remarkable at first, becomes less so. Their portfolio would have been worth more than $1 million if they had, for instance, placed half of their funds in the stock market and had an average blended return of 5% annually. In this instance, their opportunity cost would exceed $500,000.

How Can Opportunity Cost Be Predicted?

An important component of any opportunity cost prediction process is estimating and making assumptions. It is impossible to predict precisely how a different course of action will turn out in terms of money in the long run. Investors may try to predict their potential returns by looking at the historical returns on different kinds of investments. But as the well-known caveat states, "Past performance is no guarantee of future results."