Opportunity cost is defined as the potential benefit that a company, investor buyer may have gotten had they chosen this opportunity over others. Basically, it means how much of a potential benefit or gains in investment is missed by a person, had they not skipped that opportunity.
Opportunity cost is a term that plays a major role in the fields of economics. It refers to the hidden cost associated with not taking a particular decision, in the simplest of words.
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 have they 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 make educated guesses.
For example, take the recent short supply issues of the semiconductor chips. The shortage is being caused by bottlenecks in the supply chain of semiconductor chips. The companies were unable to anticipate how quickly the demand would rise and as a result, the whole industry is facing major bottlenecks issues.
The bottlenecks are a classic example of opportunity cost. This is due to the fact that companies are unable to anticipate how quickly the demand for a particular product would rise and as a result, they do not invest in expanding their production facilities and then the 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 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 return on the chosen option. The opportunity cost is positive if the return on the foregone option is less than the return on the chosen option.
The positive opportunity cost shows that the investment decision made 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 cost are implicit opportunity cost and explicit opportunity cost. Both of these opportunity costs are expressed in great deal below:
Implicit Opportunity cost
The implicit opportunity costs can be simply defined as opaque opportunity costs. This is because of the fact that 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 needs to have experience and also 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 given an opportunity to invest in it. We would totally 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
It is clear from the name that 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 and evaluate the explicit opportunity cost.
But, because you think that 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 payment which reduces the amount of capital a company may have to buy back its own shares which will result in the reduction of shareholder value.
For example, consider a company that instead of buying new capital equipment to increase its production capacity it decides to invest in government bonds. But, suddenly after investing the yield of these bonds falls dramatically. At the same time, there are bottlenecks in the 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) Making better-informed decisions.
2) Seeing the hidden opportunities.
3) Avoiding risky avenues.
4) Reduction in potential losses.
5) Finding better returns on investment
6) Avoiding pitfalls.
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 a better investment decisions. The one or two risks associated with opportunity costs are as follows:
1) The investor risks becoming too methodical.
2) The person can risk losing implicit opportunity cost.
Opportunity cost is a great methodical approach to take for investing. It helps an investor assess the potential benefits of hidden opportunities.