What Is Opportunity Cost?

What Is Opportunity Cost?

Opportunity cost is any gain you pass up by deciding on one use of your resources over others. It represents the desirable benefits you forego by choosing one alternative instead of another. While you can't predict opportunity costs with total certainty, taking them into consideration can lead to better decision making.

Formula for Calculating Opportunity Cost

You can express the opportunity cost related to investing by calculating the difference between the expected returns of two investment options. The formula is: Opportunity Cost = RMPIC − RICP, where RMPIC is the return on the most profitable investment choice, and RICP is the return on the investment chosen to pursue.

Consider a company faced with two mutually exclusive options: Option A, invest excess capital in the stock market, or Option B, invest it back into the business for new equipment to increase production. Assume the expected ROI in the stock market is 10% over the next year, while the equipment update would generate an 8% return. The opportunity cost of choosing the equipment is 2% (10% - 8%). By investing in the business, the company forgoes the opportunity to earn a higher return, at least for that first year.

Important Note on Risk

When considering two different securities, you need to take risk into account. For example, comparing a Treasury bill to a highly volatile stock can be misleading, even if both have the same expected return, making the opportunity cost appear as 0%. The U.S. government backs the T-bill, making it virtually risk-free, but there's no such guarantee in the stock market.

Opportunity Cost and Capital Structure

Opportunity cost analysis plays a crucial role in determining a company's capital structure. A business incurs an explicit cost in taking on debt or issuing equity because it must compensate lenders or shareholders, and each option carries an opportunity cost. Money used to make payments on bonds or debt can't be invested elsewhere, so the company must decide if financing growth with debt is better than with equity. Companies weigh the costs and benefits of borrowing versus issuing stock, including monetary and non-monetary factors, to minimize opportunity costs. Since opportunity cost is forward-looking, the actual rate of return for both options is unknown, making this evaluation tricky in practice.

Examples of Opportunity Costs

For a business, assume you have $20,000 in available funds and must choose between investing in securities expected to return 10% a year or purchasing new machinery. No matter which you choose, the potential profit from the other option is the opportunity cost. If you go with securities, you'd gain $2,000 in the first year, $2,200 in the second, and $2,420 in the third. With the machine, you'd net $500 in the first year, $2,000 in the second, and $5,000 thereafter. By year three, the machine becomes the better option with an opportunity cost advantage of $880.

One dramatic example is the 2010 exchange of 10,000 bitcoins for two pizzas worth about $41 at the time; as of August 2024, those bitcoins are worth over $690 million—that's the most expensive pizza ever in terms of opportunity cost.

For an individual, suppose you receive a $1,000 bonus. You could spend it on a vacation now or invest it in a 5% certificate of deposit for $1,050 next year. You'd also face opportunity costs with your vacation days—if you use them now, you won't have them later. There's no right answer, but thinking it through helps you decide what you want more.

Explicit vs. Implicit Costs

Company expenses divide into explicit costs and implicit costs. Explicit costs are things like rents, salaries, and operating expenses paid with tangible assets and recorded on financial statements. Implicit costs aren't incurred or measured accurately for accounting; there are no cash exchanges. Instead, they are opportunity costs, synonymous with imputed costs, while explicit costs are out-of-pocket expenses.

Opportunity Cost vs. Sunk Cost

A sunk cost is money already spent in the past, while opportunity cost is the potential return not earned in the future because money was invested elsewhere. When considering opportunity cost, ignore sunk costs. For instance, buying 1,000 shares at $10 each is a $10,000 sunk cost—you can't recoup it without selling, and you might not get it all back. From an accounting view, it could also be the initial outlay for equipment that's amortized but sunk since you won't get the money back.

Opportunity Cost vs. Risk

In economics, risk is the possibility that an investment's actual returns differ from projected ones, potentially leading to loss. Opportunity cost reflects the possibility that returns from a chosen investment are lower than from a forgone one. The difference is that risk compares actual vs. projected performance of the same investment, while opportunity cost compares projected performances between investments.

Accounting Profit vs. Economic Profit

Accounting profit is net income under GAAP, subtracting only explicit costs from revenue. Economic profit includes opportunity cost as an expense, comparing actual profit to what it might have been with different decisions. It's an internal value for strategic decision making.

What Is a Simple Definition of Opportunity Cost?

It's the hidden cost associated with not taking an alternative course of action.

What Is an Example of Opportunity Cost in Investing?

Consider a young investor putting $5,000 into bonds each year for 50 years at 2.5% return, ending with nearly $500,000. If half went into stocks at 5% blended return, it'd be over $1 million—the opportunity cost is over $500,000.

How Do You Predict Opportunity Cost?

Any prediction relies on estimates and assumptions; there's no way to know exactly how alternatives would play out. You might use historic returns to forecast, but past performance isn't a guarantee of future results.

The Bottom Line

While you can't predict opportunity costs with absolute certainty, they help you think through investment options and arrive at better decisions.