What is Opportunity Cost
Opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another. While financial reports do not show opportunity cost, business owners can use it to make educated decisions when they have multiple options before them. Because they are unseen by definition, opportunity costs can be overlooked if one is not careful. By understanding the potential missed opportunities one forgoes by choosing one investment over another, better decisions can be made.
BREAKING DOWN Opportunity Cost
When assessing the potential profitability of various investments, businesses look for the option that is likely to yield the greatest return. Often, they can determine this by looking at the expected rate of return for an 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 the business chooses, the potential profit it gives up by not investing in the other option is the opportunity cost.
Formula for Calculating Opportunity Cost
The formula for calculating an opportunity cost is simply the difference between the expected returns of each option:
Opportunity cost = return of most lucrative option not chosen - return of chosen option
Say option A in the above example is to invest in the stock market hoping to generate capital gains returns. Option B is to reinvest the money back into a business expecting 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 percent over the next year, and the company expects the equipment update to generate a 10 percent return over the same period. The opportunity cost of choosing the equipment over the stock market is (12 percent - 10 percent), which equals 2 percentage points. In other words, by investing in the business, they forgo the opportunity to earn the higher return.
Opportunity cost analysis also plays a crucial role in determining a business's capital structure. While both debt and equity require expense to compensate lenders and shareholders for the risk of investment, each also carries an opportunity cost. Funds used to make payments on loans, for example, are not being invested in stocks or bonds, which offer the potential for investment income. The company must decide if the expansion made by the leveraging power of debt will generate greater profits than it could make 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 foregoes 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 expected 12 percent return. For the sake of simplicity, assume the investment yields a return of 0 percent, meaning the company gets out exactly what it put in. The 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 percent rather than the expected 2 percent.
It is important to compare investment options that have a similar risk. Comparing a Treasury bill, which is virtually risk-free, to investment in a highly volatile stock can cause a misleading calculation. Both options may have expected returns of 5 percent, but the U.S. Government backs the rate of return of the T-bill, while there is no such guarantee in the stock market. While the opportunity cost of either option is 0 percent, the T-bill is the safer bet when you consider the relative risk of each investment.
Using Opportunity Costs in Our Daily Lives
When making big decisions like buying a home or starting a business, you will probably 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. Mostly, we don't think about the things 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 potential health effects, investing that $4.50 on a burger could add up to just over $52,000 in that time frame, assuming a very doable 5 percent rate of return.
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 to get a degree, there are plenty of things to consider when deciding in your personal-finance life.
While it may sound like overkill 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. Even clipping coupons versus going to the supermarket empty handed is an example of an opportunity cost - unless the time used to search through and clip coupons is better used working where more money could be earned than the savings promised by the coupons. Opportunity costs are truly everywhere we look and occur with every decision we make - big or small.
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 one invested capital 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. A sunk cost could also refer to the initial outlay to purchase an expensive piece of heavy equipment, which might be amortized over time, but which is sunk in the sense that you won't be getting it back. An opportunity cost would be to buy a piece of heavy equipment with an expected return on investment (ROI) of 5% or one with an ROI of 4%.
Again, an opportunity cost describes the returns that one could have earned if he or she invested the money in another instrument. Thus, while 1,000 shares in company A might eventually sell for $12 a share, netting a profit of $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 $3,000 difference is the opportunity cost of choosing 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. An investor has already sunk money into investments, but if another investment promises greater returns, the opportunity cost of holding the underperforming asset may rise to 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 the investor looses some or all of the principle. Opportunity cost concerns the possibility that the returns of a chosen investment are lower than the returns of a 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. Still, one could think of opportunity costs in deciding between two risks - if investment A is risky but has an ROI of 25% while investment B is far less risky but only has an ROI of 5%, even though investment A may succeed, it may not. And if it fails, then the opportunity cost of going with option B will be salient.