Business Courses/Economics 102: MacroeconomicsCourse
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Learn what is opportunity cost, including the opportunity cost definition, assessment and examples. See how to calculate opportunity cost using the formula.Updated: 11/21/2023
Table of Contents
- What Is Opportunity Cost?
- How to Calculate Opportunity Cost
- How Opportunity Cost Affects Capital Structure
- Economics Terms Related to Opportunity Cost
- Lesson Summary
Additional Activities
Opportunity Cost - A Practical Exercise:
In the following exercise, students will be presented with a real-life situation that will allow them to apply their knowledge on the notion of opportunity cost.
Scenario:
You receive a call from a notary one morning telling you that you inherited $100,000 from a distant, wealthy relative. You are so happy with this surprise - Finally, a path to wealth! You wish to invest this money for a year before using the proceeds to put a down payment on a house. You call your financial advisor and he presents you with a variety of options for investing the money. All investments are deemed to have the same risk-profile (medium-high) since you are comfortable taking the risk.
The following options are available to you.
| Investment | Expected rate of return |
|---|---|
| Low-grade corporate bonds | 8% |
| Software company stock | 10% |
| Preferred shares in a steel company | 6% |
You are particularly fond of the software company as it is a brand that you trust and you want to encourage the company's sustainability practices. However, the bonds seem more interesting since you will not have to look at stock quotes every day seeing that the bond matures in 1 year's time.
Required:
1. Compute the opportunity cost as a percentage if you were to select the software company stock as an investment vehicle.
2. What is the opportunity cost in dollars?
Solution:
1. The next best alternative is the low-grade corporate bonds since its rate of return is higher than the preferred shares.
Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue
Opportunity Cost = 10% - 8%
Opportunity Cost = 2%
The opportunity cost of selecting the software company stock as an investment vehicle is 2%.
2. The formula for opportunity cost in dollars can be given as
Opportunity Cost ($) = Opportunity Cost in % * Money invested
Opportunity Cost ($) = 2% * $100,000
Opportunity Cost ($) = $2,000
The answer is $2,000.
Table of Contents
- What Is Opportunity Cost?
- How to Calculate Opportunity Cost
- How Opportunity Cost Affects Capital Structure
- Economics Terms Related to Opportunity Cost
- Lesson Summary
Opportunity cost is an important economic principle that has a wide range of applications both in business planning and personal decisions. What exactly is opportunity cost?
Opportunity cost is the value or benefit one gives up when choosing any specific course of action. An opportunity cost definition can be best understood through the analogy of coming to a fork in the road: one is faced with multiple options but can only choose a single path, and choosing the benefits of one path comes at the cost of the benefits one could have garnered from choosing another path.
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.
In that sense, every decision in life can be viewed as an opportunity cost, whether to buy a car, get married, or have children. In terms of economics and business, opportunity cost is a beneficial tool to determine which financial road to take and which business decisions best suit goals and predicted outcomes. Because the future value of money must be taken into account, it is not enough to simply look at what will be explicitly gained by investing money in a certain project, but opportunity cost shows that one must also assess how that money could have been invested instead.
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Opportunity Cost Example
There are many opportunity cost examples, some of which apply to business and others that apply to everyday life. Although some examples may seem trivial, they can actually have long-term effects depending on what financial habits are formed. The following are a few examples of situations in which opportunity cost could play a role in decision making:
- Deciding whether to spend a gift card on a strawberry smoothie or a banana smoothie.
- Deciding whether to spend $7 every morning on coffee or consistently invest that money in a retirement account.
- Deciding whether to invest capital in refurbishing equipment or in better employee training.
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.
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The opportunity cost equation is an important tool for those who wish to make well-informed decisions. Essentially, the equation involves calculating the returns of various investment choices and thereby determining what will be lost by missing out by choosing one alternative over others. The following opportunity cost formula shows how to calculate opportunity cost:
- Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue
Although this formula seems rather simple, it can actually involve complicated calculations. The usefulness of opportunity cost in decision-making is largely predicated on making predictions about the outcomes of each potential choice and the value that can be garnered by taking a given path. As such, users of this formula must be able to make reliable estimates about the outcomes of each potential option. This requires that decision-makers take an honest look at each option and make reasonable predictions about potential outcomes, all while leaving some room for potential variance in the actual outcome.
For example, if a car manufacturer could produce 10 cars worth $8,000 each or 5 trucks worth $12,000 each per day, the opportunity cost of choosing to produce trucks instead of cars is $20,000, as reflected through the opportunity cost formula:
- Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue
- Opportunity Cost = $80,000 (selling ten cars worth $8,000 each) - $60,000 (selling 5 trucks worth $12,000 each)
- Opportunity Cost = $20,000
However, the car manufacturer must take into account whether cars are as popular as trucks and if they can sell as reliably. If trucks are much more popular than cars, then some cars might not be sold, and the trucks could be the better option for making income. Corporate decision-makers must take many variables into account before making their final conclusions about opportunity cost.
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For businesses, assessing opportunity cost often involves making decisions about capital structure. Capital structure has to do with how a company is financed and is made up of three elements: short-term debt, long-term debt, and equity. Equity refers to the infusion of capital into a business through investment, such as when investors purchase company stocks. Business leaders have to make decisions about when to take out loans and incur debt in order to invest in upgrading equipment or increasing the quality of employee training.
By using opportunity cost, these decision-makers must determine whether the money dedicated to making interest payments on a loan (i.e., the money lost by taking out a loan) could have been better used in other investment opportunities. If the return from incurring debt and making interest payments is higher than the return from investing the money that would have gone to making interest payments, then incurring debt is the best option according to opportunity cost.
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There are a number of other terms and concepts that are closely related to opportunity cost and are thus often mentioned in discussions about it, including:
- explicit costs
- implicit costs
- sunk costs
- risk
Explicit costs are costs that are visible and direct, such as spending $1,000 upgrading equipment. The opportunity cost has to do with what you could have done with that $1,000 had it been spent elsewhere.
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.
A sunk cost refers to money that has already been spent and cannot be recovered, such as money already spent on new equipment. Sunk costs do not factor into opportunity costs analyses because they have already been spent.
Finally, risk has to do with the projected return on an investment as opposed to the actual return on an investment. Those using opportunity cost must assess risk when making predictions about potential returns on different investment options. Opportunity cost assessments that do not account for risk can result in skewed decisions toward certain options that ultimately prove to be more costly than expected.
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Opportunity cost is an important notion from the field of economics. Opportunity cost refers to the value or benefit given up in pursuing an alternative course of action. This concept particularly applies to businesses, who must make decisions about their capital structure, which is composed of long-term debt, short-term debt, and equity. However, this concept also applies to decisions made in everyday life, as individuals are often faced with choosing one option or another because of the scarcity of time and resources inherent to life.
Opportunity cost is calculated by applying the following formula:
- Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue
When using opportunity cost, it is also essential to keep in mind other concepts like:
- risk, because calculations are predicated on making predictions about future investment returns
- sunk costs, or money that has already been spent and cannot be recovered
- explicit costs, or costs that are direct and visible
- implicit costs, which refer to lost opportunities for wealth creation through the use of owned resources
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Video Transcript
Opportunity Costs
Meet Lilith. She owns a small, start-up tech company that manufactures smartphones and tablets. 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.
You can think of opportunity cost as the benefit or value you give up by picking one course of action over another. In other words, the opportunity cost of a decision is the difference between the value you receive from pursuing a course action and the value that you would have received from the alternative you did not pursue. Let's look at Lilith's tech company to illustrate the concept.
Lilith can use one day to manufacture either 100 smartphones or 75 tablets. If she chooses to manufacture the phones, the opportunity cost is the difference in profits of producing 75 tablets. On the other hand, if she chooses to manufacture the 75 tablets, it costs her the difference in profits of manufacturing 100 smartphones.
Formula for Opportunity Cost
We generally want to analyze opportunity costs in terms of investment, whether it's a person or a business making that investment. We can express opportunity cost in terms of a return (or profit) on investment by using the following mathematical formula:
- Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue
Unless the investment returns are fixed and practically guaranteed to be paid (like a U.S. Treasury bond you intend to hold to maturity), you'll have to base your calculation on the expected returns. For example, on average, the stock market may have an annual return of 8%, but that doesn't mean your stock portfolio will return 8% this year.
Now, let's apply the formula to an example. Lilith's company has a 10% return when it sells smartphones, but an 18% return when it sells tablets. Let's plug in the numbers and see what happens:
- Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue
- Opportunity Cost = 18% (return on tablets) - 10% (return on cell phones)
- Opportunity Cost = 8%
If Lilith orders the production of smartphones, she'll have to give up the opportunity to earn an extra 8%. Of course, we are assuming that there is sufficient demand for tablets to expend all Lilith's production capacity on tablets.
Capital Structure Decisions
You can use an opportunity cost analysis to help you decide how to best capitalize a business. A business' capital structure is simply how a company finances its operations. Capital structure may involve a mix of long-term debt, short-term debt, and equity. Equity is the infusion of capital into a business through the sale of shares of common stock or preferred stock to investors.
What does opportunity cost have to do with a business's capital structure? If you finance your capital through debt, you have to pay it back even if you aren't making any money. Moreover, money allocated to servicing debt can't be spent on investing in the business or pursuing other investment opportunities, such as the stock and bond markets. Let's look at an example on how a business can use opportunity cost analysis to determine whether or not obtaining an infusion of capital through debt is a smart move.
Lilith wants to make more money. She could use her company's present earnings, along with a loan, to finance the upgrade of her factory. This would help to increase her profits through better products and improved efficiency and productivity. On the other hand, she could invest her company's current earnings in the stock market. Let's say that Lilith can obtain financing from a commercial lender sufficient to upgrade her facility, and she projects a 13% return after paying the cost of financing. Her financial advisor projects that investments in the stock market will yield an 11% return. Let's do the math.
- Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue
- Opportunity Cost = 13% (debt-financed return from renovation) - 11% (stock market return)
- Opportunity Cost = 2%
In other words, she'll give up a 2% return if she opts to invest in the stock market instead of financing an upgrade through debt. This illustrates the power of leverage--you can make money by borrowing if your investment of the borrowed money yields a higher rate of return than the interest charged on the debt.
Keep in mind that the calculations and analyses we have performed throughout the lesson are based on predictions and assumptions that may not hold true in the real world. For example, Lilith's factory upgrade may not yield as high of a return as she projects, and we all know that the stock market can go up or down in any given year. Consequently, realistic assumptions and projections are essential if an opportunity cost analysis is to be of any use.
Lesson Summary
Let's review what we've learned. Opportunity cost is the benefit you forego in choosing one course of action over another. You can determine the opportunity cost of choosing one investment option over another by using the following formula:
- Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue
Opportunity cost analysis is an important tool in making business decisions, including determining a business' capital structure, or how a business finances its operations, usually a mix of short and long-term loans, as well as equity. Remember that equity is the infusion of capital into a business through the sale of shares of common stock or preferred stock to investors.
However, since opportunity cost analysis looks at the future, it's important to be very realistic about your underlying assumptions.
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