Defined: Opportunity Cost, Plus Examples and Calculation

how to compute for opportunity cost

Proposed industry regulation is threatening the company’s long-term viability, but the law is unpopular and may not pass. Opportunity cost describes the difference between the value of one alternative and the value of the next best alternative. Below, we’ve used the formula to work through situations business founders are likely to encounter. self billing of tax invoices 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. The next best alternative is the low-grade corporate bonds since its rate of return is higher than the preferred shares.

What you sacrifice / What you gain = opportunity costs

how to compute for opportunity cost

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. You can use an opportunity cost analysis to help you decide how to best capitalize a business.

How is Opportunity Cost Calculated?

Opportunity cost can be applied to any situation where you need to make a choice between two or more alternatives. In economics, risk describes the possibility that an investment’s actual and projected returns will be different and that the investor may lose some or all of their capital. Opportunity cost reflects free rental monthly rent invoice template the possibility that the returns of a chosen investment will be lower than the returns of a forgone investment. Investing in securities products involves risk and you could lose money. Brex Treasury is not a bank nor an investment adviser and your Brex business account is not an FDIC-insured bank account.

Opportunity Cost and Risk

While the definition of opportunity cost remains the same in investing, the concept is a bit more nuanced because of potential differences among investments. The opportunity cost of investing in one stock over another can differ because investments have varying risks and rewards. Here’s how opportunity cost works in investing, plus the differences between opportunity cost, risk and sunk costs. Any estimates based on past performance do not a guarantee future performance, and prior to making any investment you should discuss your specific investment needs or seek advice from a qualified professional. Consider a young investor who decides to put $5,000 into bonds each year and dutifully does so for 50 years. Assuming an average annual return of 2.5%, their portfolio at the end of that time would be worth nearly $500,000.

  1. So the company must decide if an expansion or other growth opportunity made possible by borrowing would generate greater profits than it could make through outside investments.
  2. 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.
  3. The purely financial opportunity cost of choosing the CD over the CMA is $322.59 in earnings.
  4. For instance, if you’re currently thinking of buying a new car, you can use opportunity cost to identify the pros and cons of possible purchases.

How to calculate opportunity cost for each business decision.

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. Opportunity cost is important to consider when making many types of decisions, from investing to everyday choices. Knowing how to calculate opportunity cost can help you accurately weigh the risks and rewards of each option and factor in the potential long-term costs of doing so. For example, a college graduate has paid for college and now may have outstanding debt.

Opportunity cost, on the other hand, refers to money that could be earned (or lost) by choosing a certain option. When it’s negative, you’re potentially losing more than you’re gaining. When it’s positive, you’re foregoing a negative return for a positive return, so it’s a profitable move. However, since opportunity cost analysis looks at the future, it’s important to be very realistic about your underlying assumptions. Ultimately, no matter what your current circumstances may be, it’s never too late to start using opportunity cost as a tool for setting and achieving future financial goals.

While the price of kerosene is more attractive than crude, the firm must determine its profitability by considering the incremental costs required to refine crude oil into kerosene. Now we have an equation that helps us calculate the number of burgers Charlie can buy depending on how many bus tickets he wants to purchase in a given week. In short, any trade-off you make between decisions can be considered part of an investment’s opportunity cost. This theoretical calculation can then be used to compare the actual profit of the company to what its profit might have been had it made different decisions.


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