Opportunity Cost: Definition, Formula, Example, and How Does It Work?

Definition

Opportunity cost is the potential benefit a company or investor buyer may have gotten had they chosen this opportunity over others.

It means how much of a potential benefit or gain in investment is missed by a person had they not skipped that opportunity.

Opportunity cost is a term that plays a major role in economics. In the simplest of words, it refers to the hidden cost associated with not making a particular decision.

Opportunity cost is an analytical strategy whereby a person or a company can evaluate the potential benefits of applying a certain investment strategy.

Opportunity costs are by design hidden, and only after they have passed can a person analyze them with the benefit of hindsight.

The opportunity costs cannot be seen in a company’s financial report, but they a manager or a business owner makes educated guesses.

For example, take the recent short supply issues of semiconductor chips. Bottlenecks in the supply chain of semiconductor chips cause the shortage.

The companies could not anticipate how quickly the demand would rise, so the whole industry faced major bottleneck issues.

The bottlenecks are a classic example of opportunity cost. This is because companies cannot anticipate how quickly the demand for a particular product will rise. As a result, they do not invest in expanding their production facilities, and bottlenecks happen.

The Formula of Opportunity Cost

A simple way to calculate opportunity cost is by the following formula:

Opportunity Cost= F.O – C.O

Where:

F.O = Return on foregone option and,

C.O = Return on the chosen option

It is a really simple formula that can help anyone evaluate the opportunity cost of the business that they are in. It is simple subtraction.

So, the opportunity cost is negative if the return on the foregone option is greater than the chosen option’s. The opportunity cost is positive if the return on the foregone option is less than on the chosen option.

The positive opportunity cost shows that the investment decision was correct, and the negative opportunity cost shows that the investment decision made was not right.

Main types of Opportunity cost

The two main types of opportunity cost are shown in figure 1 below:

Figure 1: Main types of opportunity cost

The two types of opportunity costs are implicit and explicit opportunity costs. Both of these opportunity costs are expressed in great deal below:

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Implicit Opportunity cost

The implicit opportunity costs can be defined as opaque opportunity costs. This is because these opportunities are unclear. These investment opportunities cannot be evaluated with traditional tools available to an investor.

So, to evaluate implicit Opportunity costs, an investor must have experience and intuition. Great investors can realize great implicit opportunities. Sometimes, these opportunity costs are realized by a touch of good luck.

For example, if we could all go back to the beginning of Facebook and be allowed to invest in it. We would invest in it. Bitcoin is another great example.

Who would not buy it at the beginning when thousands of Bitcoins could be bought for pennies? Both Facebook and bitcoin are examples of implicit opportunity costs. Realizing implicit opportunity cost depends upon luck and intuition.

Explicit Opportunity cost

From the name, explicit opportunity cost is clear opportunity cost. You do not need any luck, intuition, or experience. These are clearly and easily evaluated.

Take, for example, that you are running a restaurant. You have one thousand dollars. You decide to buy one thousand dollars worth of chicken.

Now, you could have instead bought one thousand dollars worth of fish. So you can easily relate to and evaluate the explicit opportunity cost.

But you think you can make more money selling fried chicken than fish. So, you decided to buy the chicken.

After, you can easily evaluate the opportunity cost. So, here the example of restaurant owners buying chicken instead of fish is an example of explicit opportunity cost.

4. How does the opportunity cost work?

The opportunity cost can have a great impact on how a company organizes its capital structure. If a company decides to take on new debt instead of funding a new investment through share selling or even using its own reserve cash, it means that the company the opportunity cost is also highly risky.

This capital structure leads to huge debt and interest payments, which reduces the amount of capital a company may have to buy back its own shares, which will reduce shareholder value.

For example, consider a company that decides to invest in government bonds instead of buying new capital equipment to increase its production capacity.

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But, suddenly, after investing, the yield of these bonds falls dramatically. At the same time, there are bottlenecks in production.

The company loses on both sides. It would have been better if the company had invested in capital equipment. So, the company is carrying a huge negative opportunity cost.

5. Benefits of opportunity cost

The benefits of opportunity costs are as follows:

  1. Opportunity cost can help you make more informed decisions by accounting for all the potential choices available and enabling you to compare them objectively. By highlighting which option is most beneficial, it gives you a better overall picture of what is best for your situation.
  2. Opportunity cost can also help you prioritize tasks efficiently. Recognizing which task or activity will yield the highest return on investment allows you to put your efforts into the areas where they will be most beneficial.
  3. Opportunity cost can also encourage you to be creative in identifying new solutions and making unique choices that may provide more excellent value than the traditional options available.
  4. Another benefit of opportunity cost is that it clearly compares different activities and helps identify the best suited for your needs or goals. It allows you to adjust your strategy easily if something else also seems more beneficial or viable in the long run.
  5. Because it encourages evaluating every situation objectively, it makes decision-making more accessible and accurate by allowing for proper comparison between different choices or possibilities- helping maximize benefits and minimize losses in any given situation.
  6. Opportunity cost also teaches us about preparing for risk by giving us an overview of potential rewards as well as potential losses from each choice we make; this enables us to plan – taking into account all possible scenarios before we take action- so that we’re prepared no matter how things turn out in the end.
  7. As an economic concept, opportunity cost enables businesses and individuals to manage their resources better because it provides guidance when allocating resources (both money and labor) towards activities with more significant returns and away from those with smaller returns – helping improve efficiency and cut overhead costs in the process too!
  8. Lastly, understanding opportunity costs can help us think strategically while spending our money – so that not only do we get maximum value from our investment but also find new ways of optimizing our expenditure without having to sacrifice the quality or quantity of services/products provided in order achieve desired results with less money spent!
  9. Knowing these details about opportunity cost has allowed many people to become more aware of their financial decisions – so that they can make more innovative investments or purchases that have long-term benefits instead of short-term gains at higher costs!
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6. Risks associated with the opportunity cost

There are few risks or disadvantages associated with opportunity costs. After all, it is just an evaluation method for potential investments.

It helps investors in making better investment decisions. The one or two risks associated with opportunity costs are as follows:

  1. It encourages individuals to make short-term decisions that may not be the best for the long term.
  2. It can lead to an individual or company giving up potentially profitable opportunities if the opportunity cost of choosing one option is too high.
  3. Opportunity costs are generally unseen and hard to measure, making it difficult to evaluate whether a decision is truly beneficial.
  4. Opportunity costs do not take into account intangible factors such as reputation and personal values, which may impact a decision in a significant way.
  5. Opportunity costs can lead to poor allocation of resources as individuals or companies focus on specific opportunities rather than evaluating potential uses of resources more broadly.
  6. When multiple parties are involved in a decision and cannot agree on how much potential benefit each party should receive, determining the opportunity cost can become nearly impossible.
  7. Opportunity costs can become prohibitively expensive when they involve significant investments or long-term commitments that cannot easily be reversed later on down the road if circumstances change unexpectedly.
  8. There often is not enough time to adequately consider all opportunity costs before making an important decision, leading to hasty choices that may have unforeseen consequences.

7. Conclusion

Opportunity cost is a great systematic approach to take for investing. It helps an investor assess the potential benefits of hidden opportunities.