Opportunity Cost Formula: Opportunity cost describes the advantages an individual, investor, or business needs out on when choosing one alternative over another. While financial statements do not show opportunity cost, business masters can use it to make intelligent decisions when they have many options before them. Bottlenecks are often a cause of opportunity costs. Because by definition they are invisible, opportunity costs can be easily missed if one is not careful. Understanding the potential needed opportunities foregone by choosing one investment over another allows for better decision-making.
In other words, we can say Opportunity cost assists you determine, in simple mathematical expressions, what you stand to lose by choosing either option. It gives a scale that you can use to quantify the usefulness of each choice and then make a simple cost/benefit judgment. Whether you’re trying to create a budget, decide if another few years of school is right for you, or find out how much saying “yes” is really costing you, opportunity cost can help you cut straight to the chase and figure out where your preferences lie.
Opportunity Costs
Meet Rosy. She holds a small, start-up tech company that manufactures smartphones and tablets. Rosy has some important business judgments to make concerning the allocation of her company’s reserves over the next financial year. A considerable part of her decision-making examination will involve calculating and assessing opportunity cost.
You can think of opportunity cost as the benefit or value you give up by choosing one course of action over another. In other words, the opportunity cost of a judgment is the difference between the value you receive from seeking a course activity and the value that you would have obtained from the alternative you did not attempt. Let’s look at Rosy’s tech company to illustrate the concept.
Rosy can use one day to manufacture either 100 smartphones or 75 tablets. If she wants to manufacture the phones, the opportunity cost is the difference in profits of manufacturing 75 tablets. On the other hand, if she wishes to manufacture the 75 tablets, it costs her the variation in profits of manufacturing 100 smartphones.
The formula for Opportunity Cost
We commonly need to examine opportunity costs in words of investment, whether it’s a person or a business building that investment. We can express opportunity cost in terms of a return (or profit) on investment by using the following mathematical formula:
- Opportunity Cost = Return on Most Profitable Investment Choice – Return on Investment Chosen to Pursue
Except the investment returns are fixed and functionally guaranteed to be paid (like a U.S. Treasury bond you mean to hold to maturity), you’ll have to base your calculation on the foreseen returns. For example, on average, the stock market may have an annual return of 8%, but that doesn’t mean your stock holdings will return 8% this year.
Now, let’s implement the formula as an example. Rosy’s company has a 10% return when it sells smartphones, but an 18% yield when it sells tablets. Let’s plug in the numbers and see what happens:
- Opportunity Cost = Return on Most Profitable Investment Choice – Return on Investment Chosen to Pursue
- Opportunity Cost = 18% (return on tablets) – 10% (return on cell phones)
- Opportunity Cost = 8%
If Rosy orders the generation of smartphones, she’ll have to give up the opportunity to gain an extra 8%. Of course, we are assuming that there is sufficient demand for tablets to spend all of Rosy’s production capacity on tablets.
The opportunity cost of capital
The opportunity cost of capital is the incremental return on investment that a business foregoes when it chooses to use reserves for an internal scheme, rather than investing cash in a marketable security. Thus, if the proposed return on the internal project is less than the predicted rate of return on marketable security, one would not invest in the internal project, thinking that this is the only basis for the decision.
The opportunity cost of capital is the difference between the returns on the two projects.
For example, the superior management of business assumes to earn 8% on a long-term $10,000,000 investment in a new manufacturing plant, or it can invest the cash in assets for which the supposed long-term return is 12%. Barring any other concerns, the better use of the cash is to invest $10,000,000 in stocks. The opportunity cost of capital of investing in the manufacturing plant is 2%, which is the variation in return on the two investment opportunities.
This concept is not as simple as it may first seem. The person making the decision must evaluate the variability of returns on alternative investments through the time during which the cash is expected to be used.
To return to the example, superior management may be confident that the company can make an 8% return on the new manufacturing plant, whereas there may be considerable risk regarding the variability of returns from an investment in stocks (which could even be negative during the cash usage period).
Thus, the variability of returns should also be counted when coming at the opportunity cost of capital. This doubt can be quantified by assigning a probability of occurrence to different return on investment outcomes and using the weighted average as the most likely return.
No matter how the problem is approached, the main point is that there is uncertainty surrounding the derivation of the opportunity cost of capital so that a decision is rarely based on completely reliable investment information.
Opportunity Cost Example
In the following example, we will be displayed with a real-life condition that will allow them to apply their knowledge on the notion of opportunity cost.
Example 1. You receive a call from a notary one morning describing you that you received $100,000 from a distant, wealthy relative. You are so happy with this wonder – Eventually, a path to wealth! You want to invest this money for a year before using the returns to put a down payment on a house. You call your financial advisor and he presents you with a kind of option for investing the money. All investments are assumed to have the same risk-profile (medium-high) since you are happily taking the risk.
The following options are available to you.
- Investment Supposed rate of return
- Low-grade corporate bonds 8%
- Software company stock 10%
- Approved shares in a steel company 6%
You are especially fond of the software company as it is a brand that you believe and you want to support the company’s sustainability methods. However, the bonds look more attractive since you will not have to look at stock quotes every day recognizing that the bond grows in 1 year’s time.
Required:
- Calculate the opportunity cost as a percentage if you were to choose the software company stock as an investment channel.
- What is the opportunity cost in dollars?
Solution:
- The next most suitable choice is the low-grade corporate bonds since its rate of return is higher than the selected shares.
Opportunity Cost = Return on Most Profitable Investment Choice – Return on Investment Chosen to Pursue
Opportunity Cost = 10% – 8%
Opportunity Cost = 2%
The opportunity cost of choosing the software company stock as an investment carrier is 2%. - The formula for opportunity cost in dollars can be given as
Opportunity Cost ($) = Opportunity Cost in % * Money invested
Opportunity Cost ($) = 2% * $100,000
Opportunity Cost ($) = $2,000
The answer is $2,000.