Businesses, investors, and companies are constantly faced with a slew of options on where and how to invest their money to derive the most return. Understanding the concept of opportunity costs and knowing how to calculate them makes for a more efficient decision-making process as it ensures that available resources are allocated in the most optimum manner.
In the most basic form, opportunity cost is simply what you have to give up to choose an alternative option. It is the benefit an investor forgoes or the value missed as a result of choosing one economic alternative over another.
Resources are scarce and are limited in supply. Given that premise, there’s always the need to choose as to how best to maximize the resource available. The concept of opportunity cost helps us understand better the cost implication of our trade-off.
Opportunity Cost Formula
The formula for calculating opportunity costs is:
Opportunity Cost = FO – CO. Where:
FO = Rate of return on option not chosen; also, Rate of return on best alternative forgone
CO = Rate of return on the chosen option
Take note, CO here is the rate of return of the best alternative forgone and not the sum of the rate of return of all possible alternatives. This is because you can only invest in one option. Either the one you invested in or the best alternative to the one you invested in.
Step By Step Solution
- Determine the rate of return on the best alternative forgone and the rate of return on the chosen option
Determine CO (how much return your present investment has amounted to). Also, determine FO (how much return the alternative forgone would have earned you).
For instance, you bought shares in Company X and not Company Y. After a year, Company X gives you $5,000 in return, while Company Y has returned $9,000. In this case, your FO is $9,000 and CO $5,000.
- Subtract the rate of return on your chosen option from that of the best alternative forgone
From the assumption above FO – CO = ($9,000 – $5,000)
In this case, $4,000 is the opportunity cost of choosing to invest in company X over Company Y.
Types Of Opportunity Costs
Opportunity cost is of two types:
#1. Explicit Cost
This type of opportunity cost involves direct cash payments. It can be viewed as the out-of-pocket costs paid by you. This cost can be in the form of wages or rent paid, money spent to improve a property, money spent to purchase a stock, etc.
For example, if you own a Gym, the $50 you spend in purchasing new equipment can be regarded as your “explicit cost.” Your opportunity cost is what you could have used the $50 to do if you had not purchased the equipment.
#2. Implicit Cost
This type of cost does not involve a market transaction or money payment to anyone. Instead, it is the opportunity cost of utilizing the resources owned by you which could have ordinarily been used for other purposes.
For example, if the computer in a company malfunction, the implicit cost is the total production time that such a company will lose as a result of the computer breaking down.
How Do You Account For Risks When Calculating Opportunity Cost?
Most times, there are risks attached to the several available investment options. For instance, you may be faced with the option of investing in a high-risk investment like growth stock, or a low-risk investment like government bonds.
The yield from investing in the growth stock will be more but so is the risk as well. While you are likely to triple your initial investment by investing in the first option, there’s also the probability that you may lose it all.
In such cases, it becomes necessary to calculate risks as well when computing your expected return.
How do you do this? Multiply the probability of achieving a given rate by that rate, then go ahead, to sum up the results. This will give you the total predicted rate of return on each investment.
Expected Rate Of Return = (PO * X) + (OP * -Y)
Where:
PO = Probability of earning
X = Potential return
OP= Probability of losing
-Y = Potential loss
For instance, if a $2,000 investment has a 50% of earning you $1,200, and a 50% chance of you losing $800, going by the formula, the expected rate of return becomes:
ER= (PO * X) + (OP * -Y)
ER= (0.5 * 1,200) + (0.5 * -800)
ER = 600 + (-400)
ER = $200
Opportunity Cost Treatment: Accounting Profit vs. Economic Profit
There is a key difference in how opportunity cost is treated from varying financial perspectives. This variation is due to the distinction in what the accountant and economist term as “profit” is and
#1. Economic Profit / Loss
As we already mentioned, the economist considers the overall makeup of opportunity cost as including both implicit and explicit costs. Hence, for the economist, profit equals total revenue – implicit and explicit cost.
Economic Profit = Total Revenue – (Implicit Cost + Explicit Cost). For example, if a firm had a total of $15m in revenue, $10m of explicit cost, and $2m of implicit cost, then we can rightly conclude it had an economic profit of $3m (15 – 10 – 2 = 3).
#2. Accounting Profit / Loss
The accountant captures only those costs that can be measured monetarily in his books. Meaning, it does not take opportunity cost into cognizance. Hence, the accountant’s profit equals total revenue – explicit costs.
Accounting Profit = Total Revenue – Explicit Cost. in this case, if the company’s total revenue was $15m and its explicit cost $10m, then it had an accounting profit of $5m (15 – 10 = 5).
What Are The Importance Of Opportunity Costs?
Opportunity cost provides vital guidance for manufacturers and investors in business although the concept has a far more reaching value. Below are some of the ways opportunity costs helps in the everyday business scenario:
- Manufacturers can use opportunity costs to determine their “make or buy” decision. Using opportunity costs, manufacturers can assess and weigh the economic value of producing a product as opposed to buying the same product. The information derived can then act as a guide on the best option to go for.
- Opportunity costs also help allocate scarce resources to ensure that optimum productivity is obtained and maximum return is earned.
- For the investor, understanding the concept of opportunity cost can aid in knowing the investment decision to go for having calculated with reasonable certainty the variables involved.
- Opportunity cost can aid firms in their capital structuring.
What Are The Limitations Of Opportunity Cost?
The usefulness of opportunity cost in decision making cannot be overemphasized, there are however some limitations in the concept. Below are some of the inherent limitations in using opportunity cost as a decision-making tool:
#1. Estimates Are Based On Predictions
The number one limitation of opportunity cost is the fact that in reality, it’s never that easy to accurately estimate or give a figure to future returns. Investors most times base their predictions on historical data and trends, but even these are never 100% accurate.
#2. Some Decisions Cannot Be Quantitatively Measured
Another limitation when it comes to opportunity cost is the fact that not every business decision can be quantified in figures. Businesses are faced with the option of choosing between several variables regularly.
Sometimes, the impact of these decisions could be measured in figures, other times, they cannot. In such circumstances, the concept of measuring opportunity costs may be a difficult thing to do.
#3. Some Factors Cannot Be Quantified With A Dollar Figure
Finally, not all factors can be given a dollar value. Assume that you have to choose between two investments, Option A and B. A gives you a moderate return and only requires you to tie your money for three years. B on the other hand requires you to tie your money for seven years but presents a higher interest.
In this case, there’s the opportunity cost of missing out on an investment opportunity because you have your money tied up somewhere else. While this is a valid example of a real opportunity cost, quantifying it with a dollar figure might be a hard thing to do hence making the calculation
