Opportunity Cost: Definition, Calculation Formula, and Examples

By unity in Bookkeeping Posted April 14, 2022 Tags

Investing is all about decisions, and most investors can use all the help they can get. Knowing what opportunity cost is, and how to calculate and interpret it, can help investors choose the best option for them. By using opportunity cost to construct holdings strategically, investors can mitigate volatility as well as the uncertainty of returns.

That’s not to say that your past decisions have no effect on your future decisions, of course. You’ll still have to pay off your student loans whether or not you continue in your chosen field or decide to go back to school for more education. Bankrate follows a strict editorial policy, so you can trust that we’re putting your interests first. Our award-winning editors and reporters create honest and accurate content to help you make the right financial decisions. The investment information provided in this table is for informational and general educational purposes only and should not be construed as investment or financial advice.

What is opportunity cost?

If you don’t calculate opportunity cost, you potentially miss out on all sorts of opportunities that could have led to greater business success. Assume that a business has $20,000 in available funds and must choose between investing the money in securities, which it expects to return 10% a year, or using wave accounting in 2021 it to purchase new machinery. No matter which option the business chooses, the potential profit that it gives up by not investing in the other option is the opportunity cost. In another example, say a business invests a certain amount of money annually in the stock market or reinvests it in the company.

• Buying 1,000 shares of company A at $10 a share, for instance, represents a sunk cost of $10,000.
• Using opportunity cost calculations will allow you to determine what is valuable and identify the returns of the forgone alternative.
• Another huge dilemma that affects a lot of people is choosing to start a business or advance their careers.
• Therefore, there is a mathematical way to think of opportunity costs.
• In investing, the concept helps show the cost of an investment choice by showing the trade-offs for making that choice.

To minimize risks and maximize profits, investors often use various tricks of the trade to calculate and compare potential decisions. Investors try to consider the potential opportunity cost while making choices, but the calculation of opportunity cost is much more accurate with the benefit of hindsight. When you have real numbers to work with, rather than estimates, it’s easier to compare the return of a chosen investment to the forgone alternative. Investors are always faced with options about how to invest their money to receive the highest or safest return.

Module 2: Choice in a World of Scarcity

Accounting profit is the net income calculation often stipulated by the generally accepted accounting principles (GAAP) used by most companies in the U.S. Under those rules, only explicit, real costs are subtracted from total revenue. If the business goes with the securities option, its investment would theoretically gain $2,000 in the first year, $2,200 in the second, and $2,420 in the third. If you plug other numbers of bus tickets into the equation, you get the results shown in Table 1, below, which are the points on Charlie’s budget constraint. 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.

When your customers make their payments, you can easily make your credit repayments and don’t have to worry about interest rates. With Volopay’s credit line, you get a grace period in between waiting for your customers to settle your invoices. For a lot of industries, most of your competitors probably already have invoice terms. Not having invoice terms will make you less competitive in your industry.

How to Calculate Opportunity Cost

If we want to answer the question, “how many burgers and bus tickets can Charlie buy? The outstanding amount for the months that they would have otherwise been paid is considered an opportunity cost for business. Considering that plenty of big corporations have invoice terms, customers are likely to already expect it from your business when you enter the negotiation stage with them.

Formula for Calculating Opportunity Cost

However, just because there might be an upfront cost in the opportunity cost calculations, this does not mean that in the long run, this won’t change. With the cheaper plan, you could ultimately end up retaining customers for longer than a year. When making business decisions, you want to be sure that the decisions you make are the best ones in the situation.

How to Calculate Opportunity Cost: Formula and Definition

Later, you think that you could have funneled that $1,000 into an ad campaign and won 30 new customers. If you determined the difference in revenue generated by each of those two scenarios, you’d be able to find the opportunity cost. The more you can inject real data — like market-rate salaries, average rate of return, customer lifetime value, and competitor financials — into your projection, the better.

In this example, you have sacrificed $10,000 each month because you did not calculate the opportunity cost of taking on the single client for the $50,000 monthly fee. But without understanding opportunity cost, you would have no way of knowing that the taco purchases were, in fact, the best decision you could make. For this reason, opportunity cost is very important when it comes to business decisions.

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