Opportunity Cost Definition
Opportunity cost is the benefit forgone when one chooses one alternative over another. Simply put, it is the option discarded after selecting another. The opportunity cost formula example provided in this guide also shows how the opportunity cost formula is applied.
Due to limited resources, individuals, businesses, and even governments are forced to make choices. Making the best choice of all available alternatives maximizes satisfaction by settling on the most desirable option.
For example, an individual who wants to buy a house would be weighing the cost of building one themselves or buying a fully furnished house. Alternatively, they may choose to rent one. All these options are available to them, and when one is chosen, others become opportunity cost.
However, building a house may be expensive compared to renting one, and buying a fully furnished one may be quite expensive, depending on different underlying factors. If one chooses to build a house and forgo the other options, this is assumed to be the best alternative.
Opportunity Cost Formula
Opportunity cost = FO – CO
FO is Return on Most profitable investment and
CO is Return on investment taken.
Opportunity Cost Formula Example:
Assuming that the expected rate of Return (ROI) in the stock market is 15% over the next year. In comparison, the company estimates with an improvement in efficiency in production, the rate of Return would be 12% over the same period; the opportunity cost would be:
Opportunity cost = FO – CO
Opportunity cost = 15% – 12%
Opportunity cost= 3%
Simply put, by investing in a business, the company forgoes the opportunity that earns a higher return.
Types of Opportunity Cost
There are two types of opportunity costs, namely:
- Implicit opportunity cost
- Explicit opportunity cost
1. Implicit opportunity cost
It is the forgone alternative of an input resource (not necessarily money) when the resource in question is used for other purposes. For example, if a delivery van is used to help vacate office furniture, then any delivery becomes an implicit opportunity cost.
2. Explicit opportunity cost
It is the forgone expenditure alternative that could have spent money were it not used elsewhere. They can mean business day-to-day operating costs or expenses.
For example, with $20, a company can decide to use this money and pay one staff for their one extra hour, or it can use this money to publish an advert. If it uses $20 to pay one worker for an overtime hour, the advert is explicit opportunity costs.
Terms Related to Opportunity Cost
1. Comparative advantage
Comparative advantage is a production scenario where a country or a company can produce a given product at the lowest opportunity cost. For example, a manufacturer can outsource some components used in the production process from another country other than developing such components themselves.
2. Sunk costs
These are costs that the business had incurred already in the past, and it cannot recover them. These costs may not always be detrimental to the entity and sometimes cannot be avoided.
These are the triggers for decisions made in opportunity cost. For example, a man had $200, and he needed to repair his roof or take his car for servicing. If he chooses to repair his roof, the tradeoff is he cannot take his car for servicing.
Factors Affecting Opportunity Cost
Lower-income earners emphasize lower prices; hence experience opportunity costs quite often. Higher-income earners may not even consider the price of an item or service, reducing instances of experiencing opportunity cost.
Every purchasing decision made takes into account time factor. Time wastage is minimized as much as possible to allow for efficient and continued production and deliveries. The best alternative may be one that saves as much time as possible.
The utility is the enjoyment or pleasure derived from consuming a product or usage of a service. The objective of consumers is to maximize their utility as much as possible limited by obstacles such as time and price. Consumers’ utility rises with an increase in income while the consideration of price decreases.
An effort is interlinked with time. For example, it may take some time to get the one’s favorite restaurant to get their favorite snack but with greater effort to get there. Therefore, an individual may choose to dine at a restaurant much closer and compromise on the quality to save on time and effort.
What to Consider in Opportunity Cost Formula?
When calculating the opportunity cost, one has to consider the following:
i. Return on most profitable investment – This is the investment expected to yield better than the available alternatives
ii. Return on investment you choose to pursue – This is the alternative investment that may have been chosen to be pursued.
Generally, opportunity costs are calculated in terms of investment. Unless the investments generate a guaranteed return like a treasury bill, often opportunity costs are calculated as Return on investments (ROI).