Which Of These Best Describes An Opportunity Cost

What Is Opportunity Cost?

Opportunity cost represents the potential benefits that a business, an investor, or an individual consumer misses out on when choosing one alternative over another. While opportunity costs can’t be predicted with total certainty, taking them into consideration can lead to better decision making.

Formula for Calculating Opportunity Cost

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

The formula for calculating an opportunity cost is simply the difference between the expected returns of each option. Consider a company that is faced with the following two mutually exclusive options:

Option A: Invest excess capital in the stock market

Option B: Invest excess capital back into the business for new equipment to increase production

Assume the expected return on investment (ROI) in the stock market is 10% over the next year, while the company estimates that the equipment update would generate an 8% return over the same period. The opportunity cost of choosing the equipment over the stock market is 2% (10% – 8%). In other words, by investing in the business, the company would forgo the opportunity to earn a higher return—at least for that first year.

Opportunity Cost and Capital Structure

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Opportunity cost analysis can play a crucial role in determining a company’s capital structure. A business incurs an explicit cost in taking on debt or issuing equity because it must compensate its lenders or shareholders. And each option also carries an opportunity cost.

Money that a company uses to make payments on its bonds or other debt, for example, cannot be invested for other purposes. 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.

Companies try to weigh the costs and benefits of borrowing money vs. issuing stock, including both monetary and non-monetary considerations, to arrive at an optimal balance that minimizes opportunity costs. Because opportunity cost is a forward-looking consideration, the actual rate of return (RoR) for both options is unknown at that point, making this evaluation tricky in practice.

Example of an Opportunity Cost Analysis

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 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.

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.

Alternatively, if the business purchases a new machine, it will be able to increase its production. Knowing that the machine setup and employee training will be intensive, and the new machine will not be up to maximum efficiency for the first couple of years, the company estimates that it would net an additional $500 in profit in the first year, then $2,000 in year two, and $5,000 in all future years.

By these calculations, choosing the securities makes sense in the first and second years. However, by the third year, an analysis of the opportunity cost indicates that the new machine is the better option ($500 + $2,000 + $5,000 – $2,000 – $2,200 – $2,420) = $880.

Opportunity Cost vs. Sunk Cost

A sunk cost is money already spent at some point in the past, while opportunity cost is the potential returns not earned in the future on an investment because the money was invested elsewhere. When considering opportunity cost, any sunk costs previously incurred are typically ignored.

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Buying 1,000 shares of company A at $10 a share, for instance, represents a sunk cost of $10,000. This is the amount of money paid out to invest, and it can’t be recouped without selling the stock (and perhaps not in full even then).

From an accounting perspective, a sunk cost also could refer to the initial outlay to purchase an expensive piece of heavy equipment, which might be amortized over time, but which is sunk in the sense that the company won’t be getting the money back.

Opportunity Cost vs. Risk

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 the possibility that the returns of a chosen investment will be lower than the returns of a forgone investment.

The key difference is that risk compares the actual performance of an investment against the projected performance of the same investment, while opportunity cost compares the projected performance of an investment against the projected performance of another investment.

Accounting Profit vs. Economic Profit

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.

Economic profit, however, includes opportunity cost as an expense. 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.

Economic profit (and any other calculation that considers opportunity cost) is strictly an internal value used for strategic decision making.

The Bottom Line

While opportunity costs can’t be predicted with absolute certainty, they provide a way for companies and individuals to think through their investment options and, ideally, arrive at better decisions.

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Category: WHICH