What is Opportunity cost
Opportunity cost
What is opportunity cost?
We can define opportunity cost as the potential benefits that are lost when an individual, business or investor chooses a substitute over another. As the opportunity cost definition defines it to be hidden, the costs could go unnoticed very easily. To make a better decision it is important for a business to understand the possible missed opportunities whenever a business chooses one investment over another.
Formula and how to calculate Opportunity cost
Opportunity cost = FO – CO
The formula to calculate the opportunity cost is nothing but the difference between the returns that are expected from each selection. Suppose we have option A i.e. we invest in the stock market and hope to make capital gain returns. In the meantime, we have option B which says we reinvest our money into our business and buy new equipment that will enhance the efficiency of the production. As a result, operational expenses will decrease and profit margin would increase.
If we make an assumption that the return on investment when investing in the stock market is 12 per cent. However, your company would generate a 10 per cent return when provided with an equipment upgrade in the same period. If we choose to upgrade the equipment and not invest in the stock market, then the opportunity cost would be 12 – 10 per cent. We can also say that if we invest in our business we would lose the opportunity to earn more profits.
In the determination of the capital structure of a business, opportunity cost plays a very important role. A firm would incur expenses when it issues debt and equity capital in order to recompense the lenders and the shareholders and risk the investment, though each option has an opportunity cost.
For the repayment of the loan, the funds could not be used for investing in stocks or bonds. The company should make the decision that when it leverages the power of debt and make an expansion if it will make higher profits as compared to investments.
If we take the above example and make an assumption that the company invests in stocks and does not upgrade the equipment. If the value of the stocks that the company chose to invest in decreases then the company may lose money instead of earning a 12 per cent return.
Opportunity cost and risk
Risk can be described as the possibility that the projected return and actual return of an investment would be different. As a result, the investor may lose a part of the principal or the whole principal. However, opportunity cost is concerned with the likelihood that the returns earned on the chosen investment would be lesser than the return earned on the investment that is left.
The main difference between the two is that the risk would compare the projected performance and the actual performance of the investment you are investing in. Meanwhile, the opportunity cost would compare the actual performance of two different investments.
A person could still think about the opportunity cost when he decides between two risk investments. If investment A gives you a return on investment of 25 per cent but is risky, investment B gives you a return on investment of 5 per cent but is less risky. Investment A may or may not succeed, or even if it does not succeed, if you go with investment B the opportunity cost would be salient.
Example of opportunity cost
An opportunity cost example could be when you decide to buy something over another, you lose potential benefits of another item. If you decide to buy a burger for 3 dollars, you could have purchased potato fried for that money and now you lost an opportunity to buy potato fries. You lose opportunity cost almost every day by choosing among two different commodities, investments, etc.
What is opportunity cost?
The opportunity cost definition states that the opportunity cost is the potential benefits that a person loses when he chooses a substitute over another.
What are the examples of opportunity cost?
The examples are: A person gives up on going to play outside and study for the test so that he gets good marks, at an ice cream parlour, you have to choose between Belgian chocolate or cream and cookies.
What is the opportunity cost formula?
Opportunity cost = FO – CO
Where: FO stands for return on best-forgone selection and CO stands for return on the selected option.
Why is opportunity cost important?
Opportunity cost is important as it helps us in choosing the best option among the options that we have. It helps us in maximising profits by using every resource efficiently.
Disclaimer: This content is authored by an external agency. The views expressed here are that of the respective authors/ entities and do not represent the views of Economic Times (ET). ET does not guarantee, vouch for or endorse any of its contents nor is responsible for them in any manner whatsoever. Please take all steps necessary to ascertain that any information and content provided is correct, updated and verified. ET hereby disclaims any and all warranties, express or implied, relating to the report and any content therein.
Know More: Economic Order Quantity Definition, Btob Meaning, Lquidation Meaning, Mou Definition, Variable Cost Definition, Sale Definition, Organizational Behavior Definition, Operations Management Definition, Oil Refinery Definition, Quality Control Definition
What is opportunity cost?
We can define opportunity cost as the potential benefits that are lost when an individual, business or investor chooses a substitute over another. As the opportunity cost definition defines it to be hidden, the costs could go unnoticed very easily. To make a better decision it is important for a business to understand the possible missed opportunities whenever a business chooses one investment over another.
Formula and how to calculate Opportunity cost
Opportunity cost = FO – CO
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Where: FO stands for Return on best-forgone selection and CO stands for return on the selected option.The formula to calculate the opportunity cost is nothing but the difference between the returns that are expected from each selection. Suppose we have option A i.e. we invest in the stock market and hope to make capital gain returns. In the meantime, we have option B which says we reinvest our money into our business and buy new equipment that will enhance the efficiency of the production. As a result, operational expenses will decrease and profit margin would increase.
If we make an assumption that the return on investment when investing in the stock market is 12 per cent. However, your company would generate a 10 per cent return when provided with an equipment upgrade in the same period. If we choose to upgrade the equipment and not invest in the stock market, then the opportunity cost would be 12 – 10 per cent. We can also say that if we invest in our business we would lose the opportunity to earn more profits.
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What opportunity cost could tell you?In the determination of the capital structure of a business, opportunity cost plays a very important role. A firm would incur expenses when it issues debt and equity capital in order to recompense the lenders and the shareholders and risk the investment, though each option has an opportunity cost.
For the repayment of the loan, the funds could not be used for investing in stocks or bonds. The company should make the decision that when it leverages the power of debt and make an expansion if it will make higher profits as compared to investments.
If we take the above example and make an assumption that the company invests in stocks and does not upgrade the equipment. If the value of the stocks that the company chose to invest in decreases then the company may lose money instead of earning a 12 per cent return.
Opportunity cost and risk
Risk can be described as the possibility that the projected return and actual return of an investment would be different. As a result, the investor may lose a part of the principal or the whole principal. However, opportunity cost is concerned with the likelihood that the returns earned on the chosen investment would be lesser than the return earned on the investment that is left.
The main difference between the two is that the risk would compare the projected performance and the actual performance of the investment you are investing in. Meanwhile, the opportunity cost would compare the actual performance of two different investments.
A person could still think about the opportunity cost when he decides between two risk investments. If investment A gives you a return on investment of 25 per cent but is risky, investment B gives you a return on investment of 5 per cent but is less risky. Investment A may or may not succeed, or even if it does not succeed, if you go with investment B the opportunity cost would be salient.
Example of opportunity cost
An opportunity cost example could be when you decide to buy something over another, you lose potential benefits of another item. If you decide to buy a burger for 3 dollars, you could have purchased potato fried for that money and now you lost an opportunity to buy potato fries. You lose opportunity cost almost every day by choosing among two different commodities, investments, etc.
What is opportunity cost?
The opportunity cost definition states that the opportunity cost is the potential benefits that a person loses when he chooses a substitute over another.
What are the examples of opportunity cost?
The examples are: A person gives up on going to play outside and study for the test so that he gets good marks, at an ice cream parlour, you have to choose between Belgian chocolate or cream and cookies.
What is the opportunity cost formula?
Opportunity cost = FO – CO
Where: FO stands for return on best-forgone selection and CO stands for return on the selected option.
Why is opportunity cost important?
Opportunity cost is important as it helps us in choosing the best option among the options that we have. It helps us in maximising profits by using every resource efficiently.
Disclaimer: This content is authored by an external agency. The views expressed here are that of the respective authors/ entities and do not represent the views of Economic Times (ET). ET does not guarantee, vouch for or endorse any of its contents nor is responsible for them in any manner whatsoever. Please take all steps necessary to ascertain that any information and content provided is correct, updated and verified. ET hereby disclaims any and all warranties, express or implied, relating to the report and any content therein.
Know More: Economic Order Quantity Definition, Btob Meaning, Lquidation Meaning, Mou Definition, Variable Cost Definition, Sale Definition, Organizational Behavior Definition, Operations Management Definition, Oil Refinery Definition, Quality Control Definition
