In almost every situation in life, you always have a choice, which is true even when you make investment decisions. When you select something, you forego the other available options, which could have had potential benefits.
Often, you may overlook this aspect while investing because it is intangible. However, understanding the potential missed opportunity when you opt for one investment over other available choices enables better decision-making.
What is an opportunity cost?
Wondering what an opportunity cost is?
In simple terms, it is the value of the next best option you forego when you choose a particular alternative.
It is the foregone benefit potentially derived from the unselected option. Before making any decision, it is important that you evaluate the benefits of each alternative and compare these.
Analyzing opportunity costs can help businesses and individuals arrive at profitable decisions.
What is the importance of opportunity cost?
Here are four benefits of analyzing this cost.
Makes you aware of the missed opportunities
When you make a choice, you sacrifice other available options. Analyzing the cost of such foregone benefits helps you to make more accurate decisions, leading to optimum utilization of the limited resources.
Helps you choose your priorities
While determining your priorities, there is a higher chance of choosing economically more profitable opportunities.
Analyzing this cost helps you estimate the most important and profitable option based on your requirements and circumstances.
Enables relative pricing comparison
You can compare the relative prices and benefits of each option. This can be further compared for every available alternative to determine the one that provides the maximum benefits.
Helps make accurate capital structure decisions
Business owners can make the right capital structure decisions based on the analysis of these missed opportunities. Both debt and equity compensate the lenders and the shareholders, respectively, and analyzing the cost of each option help businesses optimize their capital structure.
Calculation of opportunity cost
The simple formula for calculating this cost is
Opportunity cost = FO – CO
Where FO is the return on the best foregone option and CO is the return on the chosen option.
The formula simply calculates the difference between the estimated returns of the two alternatives.
In financial analysis, this cost is factored within the present while calculating the Net Present Value (NPV). The formula is as follows:
NPV = FCF0 + (FCF1)/(1+r)1+…. + (FCFn)/(1+r)n
Where FCF is the free cash flow
R is the discount rate
N is the number of periods
When you have to choose between mutually exclusive options, it is recommended to opt for the alternative with the highest NPV.
Types of opportunity cost
Explicit opportunity cost
These are directly incurred in cash, such as raw material expenses, salaries, and rent. The explicit costs consider the alternative ways in which the funds could have been deployed.
Implicit opportunity cost
It is already incurred and includes the purchase of equipment, factory, land, or other assets. Implicit costs relate to the other available options that could be chosen to optimize the use of these assets.
Marginal opportunity cost
The marginal opportunity cost analyzes the effects of producing additional products on the business costs along with the opportunities that the business foregoes for more production.
Examples of opportunity cost
Here are some examples to help you gain further understanding of the concept of opportunity cost.
Assume that you have the choice of investing in the stock market where the expected return on investment (ROI) is 12%. The alternative is to invest in new equipment to improve production efficiency, reduce operational costs, and increase profit margins, which is expected to generate 10% returns during the same period.
In this example, the difference between the two options is 2%, which means if you invest in the business, you may miss out on the opportunity of earning higher returns by putting money in the stock market.
Another example of opportunity cost is assuming that you discover oil on one of your lands and you can sell it for INR 400 crores. A consultant calculates that if you invest INR 100 crores to extract the oil, you will be able to generate INR 600 crores in the present. The potential accounting profit by extracting oil is INR 500 crores (600 – 100). However, the economic profit would be INR 100 crores since you forego the potential sale value of INR 400 crores.
Some other examples are: Assume that you have a property, which you decide to lease to a restaurant. The missed cost of this decision is that you can no longer use that property for other purposes, such as a retail store or an office.
Similarly, when a farmer decides to sow a particular type of crop, he forgoes the option of growing other types of crops.
The application of opportunity cost
The basic opportunity cost principle is the trade-off between two or more alternatives. When you choose one, you forego the other assuming the chosen option is optimal and most valuable. When you make a decision, you consider the following four factors:
- Price, which is one of the biggest aspects but varies based on your income
- Time, there are only 24 hours in a day, and therefore, you choose the option that optimally uses its limited availability
- Effort, which is related to time because you would prefer an option that requires minimal effort to save time while maximizing the benefits
- Utility, which is essentially the value you receive and is an important consideration
Challenges of opportunity cost analysis
One of the biggest challenges is that such missed costs are difficult to determine. Often, the potential returns are estimates and not assured.
Additionally, defining non-monetary factors like efforts, risks, skills, and time is not easy. Nonetheless, comparing the potential benefits of every alternative is integral during the decision-making process.
Another challenge you may face while calculating these foregone costs is the implicit costs, which are difficult to estimate. Choosing one option over the others may require more time, energy, and other factors that are hard to define quantitatively.
Comparing missed costs also becomes challenging if the time periods for the two options differ. For example, you can invest in option A that may deliver 15% returns over two years.
Alternatively, option B has the potential to deliver 40% returns; however, the investment horizon is seven years. In this scenario, the decision will be driven by two factors – the investment timeline and the liquidity situation.
These are costs that have already been incurred and cannot be recovered in the future. Since these are already incurred, they do not impact the result of future decisions and are not considered during the capital budgeting process. Some examples of sunk costs include salaries, rental payments, and depreciation.
Business managers should be aware of the sunk cost fallacy. This is the tendency to follow through with a particular task if you have already invested your time, money, and efforts without considering if the costs outweigh the potential benefits.
While it may seem like sunk costs are fixed costs, you should remember that not all fixed costs are sunk costs. Some incurred costs can be sold and are not sunk costs.
For example, if you are shutting down your business, factory rent and equipment costs are no longer considered sunk costs. This is because the lease will have a defined end date and the equipment can be sold after accounting for depreciation.
Difference between opportunity cost and sunk costFactor Opportunity cost Sunk cost Meaning Represents the foregone returns on other options Already incurred and not recoverable Nature Implicit as the costs are notional Explicit as the costs result from actual cash flows Estimation Since implied, quantitative estimation is difficult and subjective Since actually incurred, can be accurately determined Reporting Not shown in the financial statements but can be a part of making managerial decisions Incurred costs are shown in the balance sheet and other relevant financial statements Decision making An important component as future returns are impacted based on the foregone alternatives Not relevant to future decisions as these costs are already incurred
This is a companion discussion topic for the original entry at https://jupiter.money/resources/what-is-opportunity-cost/