Opportunity cost definition
/What is Opportunity Cost?
Opportunity cost is the profit lost when one alternative is selected over another. The concept is useful simply as a reminder to examine all reasonable alternatives before making a decision. For example, you have $1,000,000 and choose to invest it in a product line that will generate a return of 5%. If you could have spent the money on a different investment that would have generated a return of 7%, then the 2% difference between the two alternatives is the foregone opportunity cost of this decision.
Opportunity cost does not necessarily involve money. It can also refer to alternative uses of time. For example, do you spend 20 hours learning a new skill, or 20 hours reading a book?
How to Calculate Opportunity Cost
To calculate opportunity cost, subtract the return on your chosen option from the return on your best foregone option. The formula is as follows:
Return on best foregone option - Return on chosen option = Opportunity cost
In both cases, the figures to use in the calculation should be your best estimate of the return that would be achieved, not an outlier value.
Examples of Opportunity Cost
The term is commonly applied to the decision to expend funds now, rather than investing the funds until a later date. Examples are:
Go on vacation now, or save the money and invest it in a house.
Go to college now, in hopes of generating a large return from the college degree several years in the future.
Pay down debt now, or use the money to buy new assets that could be used to generate additional profits.
It is easy to incorrectly include or exclude costs in an opportunity cost analysis. For example, the opportunity cost of attending college does not include room and board, since you would still make this expenditure even if you were not attending college.
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Estimation of Opportunity Cost
Opportunity cost cannot always be fully quantified at the time when a decision is made. Instead, the person making the decision can only roughly estimate the outcomes of various alternatives, which means imperfect knowledge can lead to an opportunity cost that will only become obvious in retrospect. This is a particular concern when there is a high variability of return. To return to the first example, the foregone investment at 7% might have a high variability of return, and so might not generate the full 7% return over the life of the investment.
Opportunity Cost vs. Sunk Cost
There are significant differences between opportunity costs and sunk costs. A sunk cost is a cost that has already been paid for, whereas an opportunity cost is a prospective return that has not yet been earned. Thus, a sunk cost is backward looking, while an opportunity cost is forward looking. For example, a business pays $50,000 to acquire a piece of custom machinery; this is a sunk cost. Conversely, the opportunity cost represents an analysis of how the $50,000 might otherwise have been used.
When Not to Use Opportunity Cost
There are certain situations in which the use of the opportunity cost concept is either unnecessary, impractical, or inappropriate. These include the following:
Non-economic decisions driven by emotions or values. Decisions based on emotions, personal values, or moral considerations may not align with rational opportunity cost analysis. For example, deciding to volunteer at a charity instead of working a paid job might have a high opportunity cost in terms of foregone income, but the decision is guided by personal fulfillment or altruism.
There is an abundance of resources. When resources are not scarce, the concept of opportunity cost loses relevance because trade-offs do not have meaningful consequences. For example, choosing between two equally abundant and accessible activities, like which free streaming service to use for watching shows, where neither choice significantly affects the other.
Situations with unmeasurable or intangible trade-offs. When the alternatives and their costs or benefits are difficult to quantify, using opportunity cost as a decision-making tool becomes impractical. For example, choosing between two hobbies that provide different types of satisfaction or joy, where quantifying the "value" of the trade-off is subjective.
Decisions made under complete uncertainty. If the potential outcomes of alternatives are entirely unknown, calculating opportunity costs may not be feasible. For example, investing in a highly speculative venture where probabilities and payoffs are not clear.
Habitual or routine decisions. For decisions that are made out of habit or routine, evaluating opportunity cost every time may be unnecessary. For example, drinking coffee in the morning instead of tea might technically have an opportunity cost, but it is unlikely to require deep consideration for each instance.
When the focus is on sunk costs. Sunk costs are past expenditures that cannot be recovered, and they do not factor into opportunity cost. Some people mistakenly mix the two concepts, but focusing on sunk costs can render opportunity cost irrelevant to the decision at hand. For example, continuing a project simply because a lot of money has already been invested, rather than evaluating future opportunities.
Highly regulated or fixed-outcome situations. In some scenarios, regulations or fixed outcomes limit the viable alternatives, making opportunity cost analysis redundant. For example, a company complying with mandatory environmental standards has no real alternative, so calculating the opportunity cost of non-compliance is irrelevant.
When the opportunity cost is trivial. For decisions where the opportunity cost is minimal or negligible, spending time to calculate it might not be worth the effort. For example, deciding between two grocery stores with negligible differences in prices and convenience.
By understanding the limitations and contexts where opportunity cost may not be applicable, individuals and organizations can avoid over-complicating decisions or applying the concept inappropriately.