Opportunity Cost
Opportunity cost is a possible profit an individual or a business misses by choosing one option instead of another. There’s always an opportunity cost of every decision in a situation when it’s necessary to choose between several variants.
The opportunity cost is a fully abstract concept which has no actual manifestation in the form of real income or visible loss, so it’s easy to dismiss when considering financial and economic future steps. Nevertheless, calculating and comparing opportunity costs might be a good support when making important decisions, as it helps to see financial prospects more clearly and better understand the outcomes.
How to calculate Opportunity Cost
As the opportunity costs reflect the difference between possible benefits of each possible option, at first, it’s necessary to estimate an expected profit for every option (also called the expected ROI, which stands for return on investment) and then compare the figures.
The calculation of the opportunity cost for each case is done by using the following formula:
Let’s imagine a situation when a business owner has two mutually exclusive options to invest $5000. It’s possible to invest in a well-known company’s stocks, or otherwise it’s possible to expand the owner’s business. The expected return on investing in stocks would be 15% over the following year, while the return of business expansion would make 8% return for the same year. So, if the business owner decided to invest in expansion, the opportunity cost would be 7% (15% minus 8%), which means that the business would incur a loss of potential benefit over the following year.
Opportunity Cost importance
Calculating and assessing opportunity costs might play a significant role in planning and decision-making, if done thoroughly and correctly. In some cases, investors and entrepreneurs consider opportunity costs as something unimportant as it’s difficult to see its significance in practice, but in reality competent assuming of such costs may help to make fruitful decisions.
At the same time, it’s important to remember that calculating opportunity costs involve expected numbers which might turn out to be wrong. There’s always a possibility of the expected profit of investing in stocks being actually less than predicted, and sometimes significantly less. In that case, it’s necessary to estimate opportunity costs considering that prospect, but still a more profitable opportunity cost usually stays the same with this way of calculation, too.
Examining and comparing opportunity costs might also be employed as a tool to determine the capital structure of a business, as both debt issuing and equity capital issuing imply opportunity costs, as it’s impossible to use the funds spent on repaying debts or investing in any other way. By comparing those costs, business owners are provided with the better view of possible outcomes, thus being able to make grounded decisions. When comparing corresponding opportunity costs of debt and equity issuing, businesses usually try to find an optimum and opt for variants with minimum costs.
Opportunity Cost as potential return
As there are plenty of figures to hold in mind and operate with when planning the future actions for the business, it’s worth to distinguish the opportunity cost from other similar calculations.
Opportunity costs are sometimes confused with sunk cost, but the main difference between them is that sunk cost represents an actual sum of money a company had owned and spent without a possibility to recover it, while opportunity costs always represent only hypothetical sum a company won’t actually have. In the abovementioned situation, if the business owner decides to spend $5000 on the expansion, the sum spent will be later considered as the sunk cost, while the opportunity cost will be a different figure needing calculation.
Similarly, the opportunity costs are not the same as risks. Again, the key distinction lies in the fact that opportunity costs are about the potential results of the foregone option, i.e. something clearly theoretical, while risks are comparing the actual result with the predicted one. Nevertheless, calculating opportunity costs and risks together might be useful, as comparing the opportunity costs when choosing between two risky variants is one of the ways to make a reasonable decision.
Opportunity Cost reporting
Opportunity costs aren’t required to be included in the financial reports of a company, and it isn’t represented in financial statements. Moreover, such costs are usually calculated and assessed strictly withing the company, as the calculations might contain sensitive information on the company’s other plans and intentions which might be taken later. Although, opportunity costs might be used to prepare calculations for reports intended for the company’s inner use and strategic planning. Such reports include the calculation of economic profit, in which opportunity costs are counted as expenses.
