To determine compare investment choices against each other, it is critical to understand how to calculate this kind of cost. This concept of cost is present in each and every decision an agent makes between two alternatives. For investment, purchasing, or other financial decisions, the knowing what is opportunity cost and having the ability to evaluate this cost will allow agents to make informed choices.
This concept considers the value placed on goods or services, the future time value of money, and illustrates how even simple financial decisions can create lasting impacts.
This article will explain the opportunity cost definition and illustrate the opportunity cost formula, how to calculate opportunity cost step by step, and provide examples on how to recognize this sort of cost in various scenarios. For the purposes of this article, only cost for financial decisions between two alternatives will be reviewed (although it is present in all decisions we make).
Opportunity Cost Definition
Opportunity cost is the benefit forgone from an option not chosen during a decision. This cost definition applies prominently to financial decisions, as the cost concept represents the potential benefits passed up when choosing one option over another. Evaluating this type of cost accounts for both the costs and benefits of multiple options being selected from.
What Is Opportunity Cost
Opportunity Cost Formula
For decisions between two options, the cost is calculated by subtracting the return on the option chosen from the return on the best forgone option. The values for the chosen option and the forgone option can be measured depending on the decision being evaluated.
OC = FO – CO
Where:
OC = opportunity cost
FO = return on the forgone option
CO = return on the option chosen
How To Calculate Opportunity Cost
Calculate Step by Step
- Determine the return on the forgone option.
- Determine the return on the option chosen.
- Subtract the return on the option chosen from the return on the forgone option.
Opportunity Cost Example
In the following opportunity cost example, an investor is determining which index to invest money into as to generate the highest return on investment (ROI). The investor is considering investing in the Dow Jones Industrial Average or the S&P 500 index.
To decide where his money will best grow, the investor needs to evaluate the cost present in this decision.
Based on review of historical data, the investor has gathered the following information:
Average annual ROI for the Dow Jones Industrial Average: 5.42%
Average annual ROI for the S&P 500 index: 7.96%
With this information, the investor can now evaluate the cost of choosing to invest in the Dow Jones Industrial Average. Since the investor has chosen to invest in the Dow Jones Industrial Average and will forgo the S&P 500, the values of the opportunity cost formula are as follows:
Return on the forgone option (FO): 7.96%
Return on the chosen option (CO): 5.42%
Now, the investor will populate the opportunity cost formula with these values, as follows:
OC = FO – CO
OC = 7.96 – 5.42
Next, the investor will subtract the cost of the option chosen from the cost of the forgone option to yield the cost, as shown:
OC = 7.96 – 5.42
OC = 2.54%
Here we can see that since the investor chose to forgo investing in the S&P 500 index, they also passed up on annual returns of 2.54%, as their investment would have grown more within a year in the S&P 500. The annual returns of 2.54% forgone by the investor represent the cost of not choosing the alternative opportunity in this scenario.
As this example shows, calculating for the cost of a financial decision helps individuals and businesses make sound and informed choices to maximize the benefits of a decision.
Tips for Calculating
Tip Number 1:
Calculating opportunity cost accurately for forward-facing decisions requires historical data if the potential returns are not clear. When evaluating an investment decision, the potential ROI from an investment option is not always clear. For instances such as this, try to gather as much historical data as possible to make an informed estimate of the potential ROI from an operation. Having accurate values for the returns of the options chosen and forgone will produce a true and accurate cost.
Tip Number 2:
Opportunity cost can be represented in various units, such as in currency, percentage terms, or even in numbers of goods. For example, the cost choosing between two different jobs to work could be represented in currency, as the amount of revenue forgone will be the opportunity cost of this scenario. Alternatively, for farmers deciding what type of crop to grow, the cost could be represented in terms of units of the type of crop forgone by the farmer.
Tip Number 3:
The evaluation of cost for investment decisions does not consider the need for liquidity. For example, when deciding between two investment opportunities, one option provides a higher return but requires the investment to remain untouched for a period of time. This option could cost the investor more if they miss out on a lucrative future investment opportunity because their money was unreachable over the period of time. Opportunity cost should therefore be considered in accordance with other factors when making an investment decision.
Calculating Using Microsoft Excel
Microsoft Excel can be used to effectively calculate opportunity cost. When deciding between financial decisions quickly, having an opportunity cost calculator available hastens the evaluation process.
For this example, an individual decides how to spend their time. The individual works as a consultant and charges clients $200 per hour. The consultant chooses to perform some maintenance on their vehicle, which takes 3 hours of their time and therefore represents $600 of lost revenue from time the consultant could have spent working instead. A mechanic would have charged $300 for the repairs.
In this example, the value of the forgone option is $600 since the consultant chose to forgo revenue of $600 from working three hours as they instead chose to repair their vehicle. The value of the chosen option is $300, as this is what the consultant could have made if they chose to pay a mechanic to complete the job and work the three hours instead (since $600 – cost to repair of $300 = $300 return).
To create the calculator, format the forgone option, chosen option, and opportunity cost cells as shown and insert the following formula into cell C4. This formula will subtract the chosen option from the forgone option, as follows:
=SUM(C2,-C3)
Since the forgone option was $600 of revenue and the option chosen was to repair the vehicle, which could have been completed by mechanics and allowed the consultant to still make $300, the formula will appear as follows:
Takeaways
Opportunity cost represents the benefit which is passed up when selecting one alternative over another. This cost concept applies to all financial decisions made between two or more options and should be evaluated as to make the decision which provides the most benefit.Cost predictions for future investment decisions requires historical data to ensure accuracy. This concept does not take the liquidity of an investment into consideration, so this calculation should always be used in conjunction with other evaluating factors.
