What Is Opportunity Cost?

Op♑portunity🌠 cost represents the desirable benefits someone foregoes by choosing one alternative instead of another.

While opportunity costs can't be predicted with total certainty, taking them into consideration can lead to better decision making.

Formula for Calculating Opportunity Cost

We can express the opportunity cos⛦t related to investing by calculating the difference between the expected retu💞rns of two investment options.

$\begin{aligned}&\text{Opportunity Cost} = \text{RMPIC}-\text{RICP}\\&\textbf{where:}\\&\text{RMPIC}=\text{Return on most profitable investment choice}\\&\text{RICP}=\text{Return on investment chosen to pursue}\end{aligned}$​Opportunity Cost=RMPIC−RICPwhere:RMPIC=Return on most&n💟bsp;profitable investment&nb𝓀sp;choiceRICP=Return on 🐟;investment chosen to pursue​

Consider a company💜 that is faced with the following tw🤪o 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 澳洲幸运5官方开奖结果体彩网:return on investment (ROI) in the stock market is 10% over the next year, while the company estimates that the equipment update wo𒁏uld generate an 8% return over the same time period.

The opportunity cost of choosing the equipment over the stock market i𓃲s 2% (10% - 8%). In other words, by investing in the business, the company would forgo the opportunity to earn a higher return—at least for that first year.

Opportunity Cost and Capital Structure

Opportunity cost analysis can play a crucial role in determining a company's capital structure.

A business incurs an explicit cost in taking on debt or issuing equity because it must compensate its lenders or 🌳shareholders. And each option also carri𒅌es an opportunity cost.

Money that a company usesജ to make payments on its bonds or other debt, for example, cannot be invested for other purposes.

So the company m♚ust decide if financing an expansion or other growth opportunity with debt would be better than financing it with equity.

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 opportun🙈ity costs.

Because opportunity cost is a forward-looking consideration, the actual 澳洲幸运5官方开奖结果体彩网:rate of return (RoR) for both options is unknown at that point, making this evaluation tricky i💜n practice.

Examples of Opportunity Costs

For a Business

Assume that a business has $20,000 in available funds and must choose between investing the money in 澳洲幸运5官方开奖结果体彩网:securities, which it ex๊pects to return 10% a year, or using it to purc🌳hase new machinery.

No matter which option the business chooses, the potential profi🍷t that it gives up by not investing in the other option is the opportunity cost.

If the business decides to go with the securities option, its investment would theoretically gain $𒊎2,000 in the first year, $2,200 in the second, and $2,420 in the third.

Alternatively, if the business purc🦂hases a new machine, it will be able to increase its production. But the machine setup and employee training will be intensive, and the new machine will not be up to maximum efficiency for the first couple of years.

So the company estimates that it would net an ꦯadditional $500 in profit in the first year, then $2,0ꦏ00 in year two, and $5,000 in all future years.

By these calculations, choosing the securities makes sense in the first and second years. However, by the third year, an analysis of the opportunity cost indicates that the new machine is the better option ($500 + $2,000 + $5,000) - ($2,000 - $2,200 - $2,420) = $880.

For an Individual

Individuals also 澳洲幸运5官方开奖结果体彩网:face decisions involving🐟 such missed opportunities, even if 🐻the stakes are often smaller.

Suppose, for example, that you've just received an unexpected $1,000 bonus at work. You could simply spend it now, such as on a spur-of-the-moment vacation. Or you could invest it for a future trip.

For example, if you were to invest the entire amount in a safe, 澳洲幸运5官方开奖结果体彩网:one-year certificate of deposit that pa💛id 5%, you'd have $1,050 to play with next year at this ti෴me.

You'd also face an opportunity cost with your vacation days at work. If you use some of them now with your spare $1,000 you won't have them next year (assuming your employer lets you roll them over from year to year).

As with many similar decisions, there is no right or wrong answer here, but ไit can be helpful to think it through and decide wꦆhat you want more.

Explicit vs. Implicit Costs

Company expenses are broadly divided into two categories—explicit costs and implicit costs. The former are expenses like rents, salaries, and other operating expenses that are paid with a company's tangible assets and recorded on a company' financial statements.

♓ By contrast, implicit costs are technically not incurred and cannot be measured accurately for accounting purposes. There are no cash exchangeꦿs in the realization of implicit costs.

Instead, they are opportunity costs, making them synonymous with imputed costs, while explicit costs are considered out-of-pocket expenses.

Opportunity Cost vs. Sunk Cost

A 澳洲幸运5官方开奖结果体彩网:sunk cost is money already spent at some point in the past, while opportunity cost is the potential return not earned in the future on an investment because the money was invested elsewhere. When considering the latter, any sunk costs previously incurred are typically ignored.

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 invest, and it can't be recouped without selling the stock (and you might not make the full $10,000 back).

From an accounting perspective, a sunk cost also could refer to the initial outlay to purchase an expensive piece of heavy equipment, which might be 澳洲幸运5官方开奖结果体彩网:amortized over time, but which is sunk in the sense that the company won't be geꦅtting the money back.⭕

Opportunity Cost vs. Risk

In economics, risk describes the possibility that an investment's actual a♌nd 🐼projected returns will be different and that the investor may lose some or all of their capital.

Opportu🍸nity cost reflects the possibility that the returns of a chosen investment will be lower than the returns of a forgone investment.

The key difference is that risk compares the actual performa🍰nce of a๊n investment against the projected performance of the same investment, while opportunity cost compares the projected performance of an investment against the projected performance of another investment.

Accounting Profit vs. Economic Profit

澳洲幸运5官方开奖结果体彩网:Accounting profit is the net income calculation often stipulated by the 澳洲幸运5官方开奖结果体彩网:generally accepted accounti💫ng principles (GAAP) used by most companies in the U.S. Under those rules, only explicit, real costs areౠ subtracted from total revenue.

澳洲幸运5官方开奖结果体彩网:Economic profit, however, includes opportunity cost as an expense. Th🦩is theore♔tical calculation can be used to compare the actual profit of the company to what its profit might have been had it made different decisions.

Economic profit (and any other calculation that considers opportunity cost) is strictly an internal v๊alue used for strategic decision making.

The Bottom Line

While opportunity costs can't be predicted with absolute certainty, they provide a way for companies and individuals to 澳洲幸𝄹运5官方开奖结果体彩网:think through their investment options and, ideally, arrive at better decisions.