What is an 'Opportunity Cost'
Opportunity cost refers to a benefit that a person could have received, but gave up, to take another course of action. Stated differently, an opportunity cost represents an alternative given up when a decision is made. This cost is, therefore, most relevant for two mutually exclusive events. In investing, it is the difference in return between a chosen investment and one that is necessarily passed up.
BREAKING DOWN 'Opportunity Cost'
What is the Formula for Calculating Opportunity Cost?
When assessing the potential profitability of various investments, businesses look for the option that is likely to yield the greatest return. Often, this can be determined by looking at the expected rate of return for a given investment vehicle. However, businesses must also consider the opportunity cost of each option. Assume that, given a set amount of money for investment, a business must choose between investing funds in securities or using it to purchase new equipment. No matter which option is chosen, the potential profit that is forfeited by not investing in the other option is called the opportunity cost. This is often expressed as the difference between the expected returns of each option:
Opportunity Cost = Return of Most Lucrative Option - Return of Chosen Option
Option A in the above example is to invest in the stock market in hopes of generating returns. Option B is to reinvest the money back into the business with the expectation that newer equipment will increase production efficiency, leading to lower operational expenses and a higher profit margin. Assume the expected return on investment in the stock market is 12%, and the equipment update is expected to generate a 10% return. The opportunity cost of choosing the equipment over the stock market is 12% - 10%, or 2%.
Opportunity cost analysis also plays a crucial role in determining a business's capital structure. While both debt and equity require some degree of expense to compensate lenders and shareholders for the risk of investment, each also carries an opportunity cost. Funds that are used to make payments on loans, for example, are therefore not being invested in stocks or bonds which offer the potential for investment income. The company must decide if the expansion made possible by the leveraging power of debt will generate greater profits than could be made through investments.
Because opportunity cost is a forward-looking calculation, the actual rate of return for both options is unknown. Assume the company in the above example decides to forgo new equipment and invests in the stock market instead. If the selected securities decrease in value, the company could end up losing money rather than enjoying the anticipated 12% return. For the sake of simplicity, assume the investment simply yields a return of 0%, meaning the company gets out exactly what it put in. The actual opportunity cost of choosing this option is 10% - 0%, or 10%. It is equally possible that, had the company chosen new equipment, there would be no effect on production efficiency and profits would remain stable. The opportunity cost of choosing this option is then 12% rather than the anticipated 2%.
It is important to compare investment options that have a similar degree of risk. Comparing a Treasury bill (T-bill)—which is virtually risk-free—to investment in a highly volatile stock can result in a misleading calculation. Both options may have anticipated returns of 5%, but the rate of return of the T-bill is backed by the U.S. government while there is no such guarantee in the stock market. While the opportunity cost of either option is 0%, the T-bill is clearly the safer bet when the relative risk of each investment is considered.
Using Opportunity Costs in Our Daily Lives
When making big decisions like buying a home or starting a business, you will likely scrupulously research the pros and cons of your financial decision, but most of our day-to-day choices aren't made with a full understanding of the potential opportunity costs. If they're cautious about a purchase, most people just look at their savings account and check their balance before spending money. For the most part, we don't think about the things that we must give up when we make those decisions.
However, that kind of thinking could be dangerous. The problem lies when you never look at what else you could do with your money or buy things blindly without considering the lost opportunities. Buying takeout for lunch occasionally can be a wise decision, especially if it gets you out of the office when your boss is throwing a fit. However, buying one cheeseburger every day for the next 25 years could lead to several missed opportunities. Aside from the potentially harmful health effects of high cholesterol, investing that $4.50 on a burger could add up to just over $52,000 in that time frame, assuming a very doable rate of return of 5%.
This is just one simple example, but the core message holds true for a variety of situations. From choosing whether to invest in "safe" treasury bonds or deciding to attend a public college over a private one in order to get a degree, there are plenty of things to consider when making a decision in your personal finance life.
While it may sound like overkill to have to think about opportunity costs every time you want to buy a candy bar or go on vacation, it's an important tool to use to make the best use of your money.
What is the Difference Between a Sunk Cost and an Opportunity Cost?
The difference between a sunk cost and an opportunity cost is the difference between money already spent and potential returns not earned on an investment because capital was invested elsewhere. Buying 1,000 shares of company A at $10 a share, for instance, represents a sunk cost of $10,000. This is the amount of money paid out to make an investment, and getting that money back requires liquidating stock at or above the purchase price.
Opportunity cost describes the returns that could have been earned if the money was invested in another instrument. Thus, while 1,000 shares in company A might eventually sell for $12 each, netting a profit of $2 a share, or $2,000, during the same period, company B rose in value from $10 a share to $15. In this scenario, investing $10,000 in company A netted a yield of $2,000, while the same amount invested in company B would have netted $5,000. The difference, $3,000, is the opportunity cost of having chosen company A over company B.
The easiest way to remember the difference is to imagine "sinking" money into an investment, which ties up the capital and deprives an investor of the "opportunity" to make more money elsewhere. Investors must take both concepts into account when deciding whether to hold or sell current investments. Money has already been sunk into investments, but if another investment promises greater returns, the opportunity cost of holding the underperforming asset may rise to the point where the rational investment option is to sell and invest in a more promising investment elsewhere.
What is the Difference Between Risk and Opportunity Cost?
In economics, risk describes the possibility that an investment's actual and projected returns are different and that some or all of the principle is lost as a result. Opportunity cost concerns the possibility that the returns of a chosen investment are lower than the returns of a necessarily forgone investment. The key difference is that risk compares the actual performance of an investment against the projected performance of the same investment, while opportunity cost compares the actual performance of an investment against the actual performance of a different investment.