# Opportunity Cost Definition

## What Is Opportunity Cost ?

opportunity costs represent the electric potential benefits that an individual, investor, or clientele misses out on when choosing one alternative over another. Because opportunity costs are spiritual world by definition, they can be well overlooked. Understanding the electric potential lost opportunities when a business or individual chooses one investment over another allows for better decision make.

### Key Takeaways

• Opportunity cost is the forgone benefit that would have been derived from an option not chosen.
• To properly evaluate opportunity costs, the costs and benefits of every option available must be considered and weighed against the others.
• Considering the value of opportunity costs can guide individuals and organizations to more profitable decision making.

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## Formula and Calculation of Opportunity Cost

opportunity Cost = FO − CO where : FO = Return on best predate choice CO = Return on chosen choice \begin { aligned } & \text { Opportunity Cost } =\text { FO } -\text { CO } \\ & \textbf { where : } \\ & \text { FO } =\text { Return on best predate option } \\ & \text { CO } =\text { Return on chosen choice } \\\end { aligned } ​Opportunity Cost=FO−COwhere : FO=Return on best waive optionCO=Return on chosen option​

The recipe for calculating an opportunity cost is plainly the dispute between the expect returns of each option. Say that you have option A—to invest in the stock market, hoping to generate capital gain returns. interim, choice B is to reinvest your money spinal column into the business, expecting that newer equipment will increase production efficiency, leading to lower operational expenses and a higher profit allowance .

Assume the expect return on investment ( ROI ) in the standard market is 12 % over the following year, and your company expects the equipment update to generate a 10 % return over the same menstruation. The opportunity price of choosing the equipment over the store market is ( 12 % – 10 % ), which equals two share points. In other words, by investing in the business, you would forgo the opportunity to earn a higher retort .

While fiscal reports do not show opportunity costs, commercial enterprise owners often use the concept to make educate decisions when they have multiple options before them. Bottlenecks, for exemplify, much result in opportunity costs.

## What Opportunity Cost Can Tell You

opportunity cost analysis plays a crucial function in determining a business ’ sulfur capital structure. A fast incurs an expense in issuing both debt and equity capital to compensate lenders and shareholders for the risk of investment, however each besides carries an opportunity cost .

Funds used to make payments on loans, for exercise, can not be invested in stocks or bonds, which offer the electric 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 .

A tauten tries to weigh the costs and benefits of issuing debt and stock, including both monetary and nonmonetary considerations, to arrive at an optimum symmetry that minimizes opportunity costs. Because opportunity cost is a advanced consideration, the actual rate of return ( RoR ) for both options is obscure today, making this evaluation catchy in practice .

Assume that the caller in the above exercise forgoes new equipment and rather invests in the stock market. If the selected securities decrease in value, the company could end up losing money rather than enjoying the expected 12 % reappearance .

For the sake of chasteness, assume that the investment yields a reelect of 0 %, meaning the ship’s company gets out precisely what is put in. The opportunity cost of choosing this option is 10 % to 0 %, or 10 %. It is evenly potential that, had the company chosen new equipment, there would be no effect on production efficiency, and profits would remain stable. The opportunity monetary value of choosing this option is then 12 % rather than the ask 2 % .

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 misinform calculation. Both options may have expected returns of 5 %, but the U.S. government backs the RoR of the T-bill, while there is no such guarantee in the banal market. While the opportunity cost of either choice is 0 %, the T-bill is the dependable bet when you consider the proportional hazard of each investment .

### Comparing investments

When assessing the potential profitableness of versatile investments, businesses look for the option that is likely to yield the greatest return. Often, they can determine this by looking at the expect RoR for an investing fomite. however, businesses must besides consider the opportunity price of each alternate option .

Assume that, given $20,000 of available funds, a business must choose between investing funds in securities or using it to purchase modern machinery. No matter which option the business chooses, the likely net income that it gives up by not investing in the early choice is the opportunity monetary value . If the business goes with the inaugural option, at the end of the inaugural year, its investment will be deserving$ 22,000. The recipe to calculate RoR is [ ( Current Value – Initial Value ) ÷ Current Value ] × 100. In this exemplar, [ ( $22,000 –$ 20,000 ) ÷ $20,000 ] × 100 = 10 %, so the RoR on the investment is 10 %. For the purposes of this example, let ’ s assume it would net 10 % every year after vitamin a well. At a 10 % RoR, with compounding interest, the investment will increase by$ 2,000 in year 1, $2,200 in year 2, and$ 2,420 in year 3 .

alternatively, if the business purchases a new machine, it will be able to increase its production of widgets. The machine apparatus and employee prepare will be intensive, and the new machine will not be up to maximum efficiency for the first couple of years. Let ’ s assume it would net the company an extra $500 in profits in the first year, after accounting for the extra expenses for train. The clientele will net$ 2,000 in year 2 and $5,000 in all future years . Since the party has limited funds to invest in either option, it must make a choice. According to this, the opportunity cost for choosing the securities makes sense in the first base and second gear years. however, by the third base year, an analysis of the opportunity cost indicates that the fresh machine is the better option ($ 500 + $2,000 +$ 5,000 – $2,000 –$ 2,200 – $2,420 ) =$ 880 .

## The Difference Between Opportunity Cost and Sunk Cost

A dip cost is money already spent in the by, while opportunity price is the electric potential returns not earned in the future on an investment because the capital was invested elsewhere .