What is Opportunity Cost?
Opportunity cost is a trade-off. Every choice you make, there is something to consider. Opportunity cost represents the benefits an individual, investor or business misses when choosing one alternative over another. Hence, why it’s a factor in time value of money.
Opportunity costs can be easily overlooked if you’re not careful. Understanding the potential missed opportunities by choosing one investment over another will help you make better decisions. Thus, achieving optimal results.
Now that you know what opportunity cost is, let’s discuss why experts break down opportunity costs into two categories – explicit and implicit.
Explicit opportunity costs are out-of-pocket costs or direct costs to a person or business.
If you own a Cupcake Company and you add a new item to the menu that requires $50 in labor, ingredients, electricity, and water. Your explicit cost is what you could have done had you not added that new item to the menu. You could have spent it on a new oven, bathroom renovation, or added a different menu item.
Implicit opportunity costs are resources already owned by the individual or business that could have been put to some other use. It’s not a direct cost, but rather the lost opportunity to generate income through those resources.
For example, if you have a warehouse that you use as a storage facility for your Cupcake Company. The implicit cost is the rental income you could have generated if you leased it to another company. Instead of using it for your own company, you could have collected a monthly check. It doesn’t cost you anything to use the warehouse yourself, but you are giving up the opportunity to generate income from the property.
Calculating Opportunity Cost
The formula for calculating an opportunity cost is simple. Take the difference between the expected returns of each option and the one with the most, essentially “wins.”
Take option A, which is to invest in the stock market hoping to generate returns. Option B is to reinvest your money back into your Cupcake Company, expecting that newer equipment will increase production efficiency. Thus, leading to lower operational expenses and a higher profit margin.
Let’s assume the expected return on investment in the stock market is 10 percent, and your company expects the equipment update to generate an 8 percent return over the same period. The opportunity cost of choosing the equipment over the stock market is 10% – 8% = 2%. Thus, by investing in the business, you would forgo the opportunity to earn a higher return.
Even though opportunity cost is heavily rooted in economics and finance, any individual or business can apply the concepts. Such as assessing the potential profitability of various investments, or reassessing any missed opportunities. Overall, the goal is to apply the concept, making an informed decision that enhances yourself or your company.