Opportunity Cost

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Opportunity cost represents the benefit that is forgone when one alternative is chosen over another. Whenever you are presented with two options, choosing one option over the other would bring you an opportunity cost. This concept bases on the rationale to critically analyze all the available options/choices before making a decision.

Simply put, the term ‘Opportunity cost’ refers to what you’d have to give up to gain something.

Opportunity Cost Examples

  1. Let’s suppose you have $10. You can use this money to buy a KFC Mighty Zinger or an Accounting textbook for your upcoming quiz. If you choose to buy a burger, you won’t be able to afford the Accounting textbook. The opportunity cost to enjoy a KFC Mighty Zinger, therefore, is an Accounting textbook. 

Similarly, if you opt for the latter and buy the textbook instead, you will be out of money to buy yourself a burger. So, the opportunity cost to buy a textbook is a KFC Mighty Zinger. For each choice that you make, you forsake the next best alternative that makes the opportunity cost of the chosen alternative.

  1. Bill is just a week ahead of his 3-month long Summer vacations. This year he wants to learn horse riding and swimming both. However, both the courses are 3-months long, and he can schedule either of them, only. If Bill chooses to learn swimming, he will have to let go of the option of horse-riding.

Or on the contrary, he would have to lose out the option of swimming to learn horse-riding. In either case, the course that he drops is the opportunity cost of the course that he adopts. The opportunity cost of learning swimming is horse-riding, and vice-versa.

  1. The government has to allocate the budget of $1,000 billion for the upcoming year between defense, education, health, and infrastructure. If the government decides to spend $500 billion on defense and $500 billion on education, there would be nothing left back to spend on health and infrastructure. Thus, the opportunity cost of government investment in education and defense operations is health and infrastructure projects. 

Similarly, if the government plans to spend the entire $1,000 budget on health and modern infrastructure, then the same budget cannot be used for the next best alternatives i.e. education and defense. That, in a nutshell, defines how opportunity cost works.

Opportunity Cost Explained

The simplest definition of opportunity cost is ‘the price of the next best alternative that you would have opted for, had you not made your first choice’.

Let’s understand this through the following example.

Harry has won $500 in a lottery. He is faced with several options to spend the prize money.

  • Buy an iPhone worth $500. (10/10)
  • Buy a PS4 worth $500. (6/10)
  • Buy a 7-day trip to Paris for $500. (7/10)
  • Buy an Xbox worth $500. (9/10)

While he wishes to buy all the above items, he can only afford to buy one. The rating parallel to each item represents how much Harry can benefit from each item.

What is the opportunity cost of buying an iPhone? 

Is it the combination of all the other items i.e. a PS4, a 7-day trip to Paris, and an Xbox? 

No, opportunity cost only represents the value of the next best alternative forgone. 

The opportunity cost of buying an iPhone is thus, buying an Xbox. Had he not bought himself an iPhone, he would most likely have bought an Xbox as it tends to be the next most beneficial alternative.

By buying an iPhone, Harry has lost the benefit that he could have availed from an Xbox.

Opportunity Cost Formula

Understanding and critically analyzing the potential missed opportunities for each investment chosen over another, promotes better decision making. 

The financial reports and statements of a company do not show Opportunity costs. Estimating and evaluating the opportunity cost of a decision is purely management-based. Business owners use the underlying concept of these costs to make an educated decision when faced with multiple options to choose from. 

Opportunity cost is calculated by using the following formula,

Opportunity\: cost\: = RFO - RCO
  • RFO = Return on the next best-forsaken option
  • RCO = Return on the chosen option

Here is how this formula works:

You have $10 million and you choose to invest it in a project that yields an annual return of 5%. Exploring more options, you could have invested the same $5 million into another project that would have yielded a 10% annual return. 

Return on the chosen option = 5%,   Return on the next best forsaken option = 10%

RFO – RCO = 10% – 5%

Opportunity Cost = 5%

The differential 5% return is the lost opportunity cost of this decision i.e. (to invest in a 5% return yielding project). The formula to calculate opportunity cost is simply the difference between the foreseen returns of each alternative.

While the decision to choose a 5% return may seem irrational, real-life decisions may be different. For example,

A company is faced with an option to invest $8 million in stocks to generate capital gains. Or reinvest the same amount within the business to launch a new product line and earn more profits.

Assuming, the expected return on Option A (investment in stocks) is 7% and that on Option B (reinvestment in business) is 9%. The opportunity cost of investing in Option A (investment in stocks) is 2% (9%-7%). In other words, by investing in stocks, the company would lose the opportunity of launching a new product line and earning more profits. 

Opportunity Cost is Estimate-Based

However, the concept of opportunity cost is forward-looking, and everything is based on estimates. The return of 7% and 9% (refer to the above example) is expected and the actual rate of return is unknown. 

Assumption

The company reinvests in the business instead of investing in the stock market. 

There is an utter possibility of the new product to fail; the concerned audience may not like it, or the targeted sale volume might not be achieved. In either case, the expected 9% rate of return can turn out to be a wrong estimate. 

If the product faces a backlash (as the above-taken assumption), the company could end up bearing an opportunity cost of 7%, instead of enjoying the return of 9%.

Reapplying the OC formula, the return on the stock investment is 7%, whereas the Return on reinvestment in business is now 0% (assuming the product launch failed).

Therefore, the new OC is:

  • Return on the next best forsaken option (RFO) = 7%
  • Return on the chosen option (RCO) = 0%
  • Opportunity Cost = RFO – RCO 
  • Opportunity Cost = 7% – 0% = 7%

Time Based Opportunity Cost

The concept of Opportunity cost is not limited to monetary decisions. It makes its way to all our daily and personal decisions. Each second that you spend doing a particular activity could have been spent doing something different. Therefore, each act that you do has a cost of something that you didn’t do at that particular time.

For instance, the time you spend learning Accounting could have been spent in learning Economics. The opportunity cost learning Accounting is, thus, learning Economics.

Talking a little more like economists, the term ‘Opportunity costs’ refers to the decision of spending your funds now or investing them to earn a return. For each penny that you hold in your pocket, the opportunity cost is the interest that you could have earned by investing the same penny in an investment vehicle.

Examples:

  • Buy a car for $8,000 today or invest the same in stocks to earn an annual return of $10%. The opportunity cost of buying a car today is thus the potential annual return that you could earn in the future. 
  • Payback your loans today to save the interest expenses or use the same to buy assets and generate future revenue. The cost of saving your interest expenses is the potential revenue that you can make from the assets that you buy from the loaned amount.
  • Sell your car for $3,000 today or use it for another 2 years. The cost of selling your car for an immediate receipt of $3,000 is the ability to use it for another 2 years.

Opportunity Cost in Businesses

When applied to a business, the idea of opportunity cost refers to the potential profit that a business could have earned by investing the same assets, capital, equipment, resources, and funds into a different project, product, or service.

All businesses consider the relevant costs, incremental costs, and all implicit and explicit opportunity costs before taking any business decision. Below are the examples of some business decisions based on a critical evaluation of opportunity costs and potential revenue.

  • Limiting factor decisions
  • Make or buy decisions
  • Continuing operations or shutdown decisions
  • Joint product & further processing decisions

A business considers opportunity costs in terms of several factors including labor-hours, machine-hours, mechanical output, raw material etc. However, the cost evaluation process of a business is different and includes the analysis of explicit & implicit costs.

Explicit Costs

An explicit cost is an incremental cost the or direct payment that is made in the course of running a business. These costs are specifically incurred and are booked as an expense, resulting in actual cash outflows e.g. wages, salaries paid to employees, rent, price of raw materials, etc.

Example:

Flair Bakery is planning to introduce a new Smoked Beef Lasagna recipe. To prepare the said dish, Flair Bakery would need to hire two trained chefs. Also, it would require new Pasta cutting machines and a special set of sauces. The Finance team estimates an expense of $200 upon the launch of this new menu item.

Considering the above example, $200 is the explicit opportunity cost of introducing the Smoked Beef Lasagna at Flair Bakery. The same $200 could have been used to introduce another recipe, to buy other latest machinery or any other business activity. 

Implicit Costs

Implicit costs do not represent direct payments, but the usage of already-owned resources. Implicit costs make the best use of the concept of Opportunity costs. These costs trigger no additional payments or cash outflows, but rather the loss of an opportunity to earn from the existing resources differently. 

Example:

Sturdy Constructors Inc. is an established real-estate company. It has several buildings and flats around the town that are tenanted and sold. However, due to some business operations’ expansion, a building was vacated. The board of directors decided to set up the office headquarters within the vacated building. Before being used for business purposes, the building was rented out for $3500 per annum.

In the above example, Sturdy Constructors Inc. has won an opportunity to expand its business and make more profits than before for no additional cash outflows. However, it has lost the annual rental income of $3500. Thus, the implicit opportunity cost of business expansion born by Sturdy Constructors Inc. is $3500 per annum. 

Limitations of Opportunity Costs

The idea of Opportunity cost helps you to better analyze the potential options and opportunities available at the time of decision-making. However, there are some limitations to this concept which are as follows,

  • Opportunity cost cannot always be authentically estimated at the time of decision-making. Particularly, in businesses when the variability of the rate of return is higher. 
  • Making a quantitative comparison between the two alternatives is not always possible. It requires a common measuring unit i.e. time, money spent, man-force used etc.
  • Some factors of production and resources might have only one use. For the utilization of such factors/ resources, there is no opportunity cost. This opposes the basic idea of Opportunity cost.

Conclusion

  • Opportunity cost is the price of the next best alternative forgone, when one option is chosen over another. It is not the combination of all the available options but only the next best option.
  • Opportunity cost = Return on the next best Forsaken Option – Return on the Chosen Option
  • Considering opportunity costs navigates you to more profitable and successful decisions by evaluating the feasibility of all the available options.
  • In addition to potential returns, the relative risks involved with each option must also be assessed to reach the right decisions.