Defined: Opportunity Cost, Plus Examples and Calculation

how to compute the opportunity cost

Inversely, the opportunity cost of the 8 percent return is the 10 percent return. Even if you select the 10 percent return – and therefore earn a better overall return – your opportunity cost is still the next best alternative. Any estimates based on past performance do not a guarantee future performance, and prior to making any investment you should discuss your specific investment needs or seek advice from a qualified professional. Opportunity costs are a factor not only in decisions made by consumers but by many businesses, as well. Businesses will consider opportunity cost as they make decisions about production, time management, and capital allocation. As an investor, weighing out the opportunity cost of each investment decision you make can help you make the most prudent decisions.

Opportunity cost vs. sunk cost

Kerosene, a product of refining crude, would sell for $55.47 per kilolitre. While the price of kerosene is more attractive than crude, the firm must determine its profitability by considering the incremental costs required to refine crude oil into kerosene. Opportunity cost is one of the key concepts in the study of economics and is prevalent throughout various decision-making processes. The opportunity cost is the value of the next best alternative foregone.

Other Costs in Decision-Making: Incremental Costs

how to compute the opportunity cost

Financial analysts use financial modeling to evaluate the opportunity cost of alternative investments. By building a DCF model in Excel, the analyst is able to compare different projects and assess which is most attractive. Second, the slope is defined as the change in the number of burgers (shown on the vertical axis) Charlie can buy for every incremental change in the number of tickets (shown on the horizontal axis) he buys. The slope of a budget constraint always shows the opportunity cost of the good that is on the horizontal axis. If Charlie has to give up lots of burgers to buy just one bus ticket, then the slope will be steeper, because the opportunity cost is greater.

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  1. If a potential investment doesn’t meet their hurdle rate, then investors won’t make the investment.
  2. 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).
  3. Sunk costs should be irrelevant for future decision making, while opportunity costs are crucial because they reflect missed opportunities.
  4. As of March 2024, those 10,000 bitcoins would be worth over $700 million.
  5. Opportunity costs can be easily overlooked because sometimes the benefits are unrealized, and therefore, hidden from view.

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. In this example, the firm will be indifferent to selling its product in either raw or processed form. However, if the distillation cost is less than $14.74 per barrel, the firm will profit from selling the processed product. A land surveyor determines that the land can be sold at a price of $40 billion.

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Investors might also want to consider the value of time in their calculation of opportunity cost. On one hand, you have a high interest rate for a longer period of time, but on the other,  your money is tied up that much longer and unavailable to you to invest in something else. The primary limitation of opportunity cost is that it is difficult to accurately estimate future returns. You can study historical data to give yourself a better idea of how an investment will perform, but you can never predict an investment’s performance with 100% accuracy.

When considering opportunity cost, any sunk costs previously incurred are typically ignored. For example, a college graduate has paid for college and now may have outstanding debt. This college tuition is a sunk cost, since it’s been incurred and cannot be recovered. If the graduate decides to change career fields, any decision should factor in future costs to do so rather than costs that have already been incurred. So the opportunity cost of changing fields may include more tuition and training time, but also the cost of the job this is left behind (as well as the potential salary of a job in the new field). is an independent, advertising-supported publisher and comparison service. We are compensated in exchange for placement of sponsored products and services, or by you clicking on certain links posted on our general and special accounting journals site. Therefore, this compensation may impact how, where and in what order products appear within listing categories, except where prohibited by law for our mortgage, home equity and other home lending products.

However, a fall in demand for oil products has led to a foreseeable revenue of $50 billion. As such, the profit from this project will lead to a net value of $20 billion. Opportunity cost helps inform efficient business strategy by ensuring that companies allocate resources in the most effective manner possible in an effort to achieve their business objectives.

how to compute the opportunity cost

There’s no way of knowing exactly how a different course of action will play out financially over time. Investors might use the historic returns on various types of investments in an attempt to forecast their likely returns. However, as the famous disclaimer goes, “Past performance is no guarantee of future results.” While the definition of opportunity cost remains the same in investing, the concept is a bit more nuanced because of potential differences among investments. The opportunity cost of investing in one stock over another can differ because investments have varying risks and rewards. Here’s how opportunity cost works in investing, plus the differences between opportunity cost, risk and sunk costs.

With that choice, the opportunity cost is 4%, meaning you would forgo the opportunity to earn an additional 4% per year on your funds. 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). Individuals also face decisions involving opportunity costs, even if the stakes are often smaller. Opportunity cost represents the potential benefits that a business, an investor, or an individual consumer misses out on when choosing one alternative over another.

Opportunity cost can be applied to any kind of decision that involves a trade-off, whether that involves time, money or other resources. In economics, everything comes at the cost of something else, so picking one option causes an individual or business to miss out on a different option. If the organization opts to put its money into the income-producing securities instead of the new equipment, the opportunity cost will be 6% of the principal invested in the first year.

Let’s say you are deciding to invest in either Company A or Company B. You choose to invest in company A, which provides a return of 6% in one year. They represent the income or other benefits that could possibly have been generated had you made the alternative choice. If a man marries someone, he cannot choose another person to be his spouse. If an individual chooses to go to one university full-time, that will require many spent either in class or studying that cannot be used for other purposes. Accounting profit is the net income calculation often stipulated by the generally accepted accounting principles (GAAP) used by most companies in the U.S.

In contrast, opportunity cost considers the loss of potential returns from an alternative investment decision. “Sunk cost refers to the past costs that you have incurred,” says Ahren A Tiller, Esq., Bankruptcy Law Specialist. “Let’s say you’ve invested in company X but gained nothing. The money you spent is a sunk cost, and it can’t be recovered. You can’t do anything about it, making it irrelevant in your decision-making.”

Follow these steps, and your result will be provided at the bottom of the calculator. If you want to know more, read the following sections to go deeper into its calculation methods and formulas. Where P and Q are the price and respective quantity of any number, n, of items purchased and Budget is the amount of income one has to spend. You can see this on the graph of Charlie’s budget constraint, Figure 1, below. Opportunity cost can cause individuals to forgo everyday luxuries and even regular experiences.

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