What is Opportunity Cost?
Opportunity cost is the return on an investment/opportunity you missed out on, compared to the return on the investment that you chose. To determine what was lost (or gained), opportunity cost may be calculated as a number or a ratio.
How to Find Opportunity Cost
No two business opportunities produce the same gains, so comparing two to see the proportion of gain to loss makes sense (as long as the two opportunities have similar risk).
The opportunity cost formula is the difference between the expected rate of return on two options. It is calculated as follows:
Opportunity Cost Formula Example
If you inherit $15,000 from a long-lost aunt, what can you do with it? Let’s assume you’re feeling responsible and want to invest it. You’re considering two choices: You can invest the money in a mutual fund or in a passbook savings account. You choose to save the money in your passbook account for the first year.
After one year, you decide to examine the opportunity cost of choosing the bank over the mutual fund.
Bank interest rate: 1% (CO)
Mutual fund return: 3% (FO)
Opportunity cost = FO - CO
Opportunity cost = 3% - 1%
Opportunity cost = 2%
Difference of Opportunity Cost Between Investments
Calculating the difference of opportunity costs is helpful to understand the pros, cons, and trade-offs involved when choosing one investment over another.
Choosing investments carefully means considering multiple factors, including opportunity cost. Although no one can tell with certainty which investment is better, if the investor examines the company’s annual report, website, and financial statements carefully, they may be able to project expected returns.
Conversely, the bank CD returning 5% looks like a better investment (considering it’s risk free). Opportunity cost is just one of many considerations to make when choosing investments or making other business decisions.
Ratio of Opportunity Cost
Ratio of opportunity cost is a second formula that calculates opportunity cost but uses proportions to demonstrate the value of each choice. This proportion illustrates how much of what’s been sacrificed versus what’s been gained from the alternative.
Ratio of Opportunity Cost Formula
Opportunity cost = what you sacrifice by making the choice / what you gain by making the choice
Ratio of Opportunity Cost Example
Let’s assume that a college student is considering two jobs:
Salesperson: Salary is $20 per hour
Waiter: Salary is $10 per hour
The student chooses to wait tables at a restaurant because it fits in better with his class schedule. Although that’s a major benefit, his ratio of opportunity cost is:
Ratio of opportunity cost = what the student sacrifices by making the choice / what he gains by making the choice
Ratio of opportunity cost = $20/$10 = 2/1 = 2
The ratio of opportunity in this example states that for every dollar earned working for one hour as a waiter, the college student sacrifices $2 working as a salesperson.
Opportunity Cost vs. Trade Off
Opportunity cost is all about the most basic of economic concepts: trade-offs. It's a notion inherent in almost every decision of daily life, including investing.
If you make an investment choice, you forgo other options for now. What’s been given up may turn out to have been the better choice. This is why opportunity cost is best measured in hindsight. It is impossible to know the end outcome of any investment.
Opportunity Cost vs. Risk
Opportunity cost and risk aren’t quite the same thing in investments. Opportunity cost compares the actual cost of the performance of one investment against another. Risk compares the the actual performance of an investment against the projected performance of the same investment
Opportunity cost = compares actual cost of an investment against the actual cost of a second, different investment
Risk = compares the actual performance of an investment against the projected performance of the same investment
Opportunity Cost vs. Sunk Cost
A sunk cost represents money spent. Opportunity cost represents money that could have been earned if the money was invested in a different way.
Let’s assume that our inheritor (from the example above) chooses to purchase $15,000 of stock. That $15,000 is a sunk cost, spent to purchase the stock regardless of whether it’s sold or held. The opportunity cost is the 5% of the CD, representing what he could have earned if the money was invested differently.
Example of Sunk Cost vs. Opportunity Cost
In business, the sunk cost is often considered before undertaking a project. For example, a food company may spend $10,000 on a market research study to assess whether repackaging their orange juice will make a difference in brand recognition and awareness. No matter the outcome of the market research study, $10,000 is a sunk cost.
The opportunity cost of the same project may be the cost to redesign (or not redesign) the packaging. If market research indicates that the company can raise consumer awareness by changing the design of their package – and the company chooses NOT to go ahead with the research – the opportunity cost is the difference in sales between what they earned and what they could have earned.
Let’s assume the company commissions the study and changes the packaging. There’s a sudden spike in demand and the company cannot keep up with production.
The sunk cost is still $10,000 for the market research study, but now the opportunity cost is the money potentially lost from the bottlenecked system. Lost opportunity costs lost due to bottlenecks are another calculation many businesses undertake to assess potential losses from missed opportunities.
Using Opportunity Cost to Compare Investments
In business, opportunity cost may be used to determine a business’ capital structure. Both equity and debt carry expenses and opportunity costs to compensate shareholders and lenders alike. Funds used to repay shareholder loans, however, aren’t available to invest in stocks. The opportunity cost between the two choices (paying off the loan or investing in the stocks) must be weighed and considered using the opportunity cost of each.
