Opportunity Cost: Definition, Formulas, and Examples
Far more often than not, we find ourselves in situations that demand sober and wise decision making. We all had to forego attractive alternatives due to necessity at some point. Opportunity cost refers to a fundamentally significant economic term. The concept defines and describes the analytical process undergone by individuals or boards in making government, business or personal decisions.
The notion includes considerations that determine the most seemingly lucrative opportunities in which to invest at the expense of others. More specifically, opportunity cost refers to the benefits foregone by making investments in an opportunity at the expense of a more lucrative one. We shall examine how business opportunity is calculated, and how excellent business people identify the most financially rewarding opportunities. We must first examine several economic concepts to do so effectively.
General Information about Opportunity Cost
The way we run our lives and business undertakings determines how efficiently we choose from the myriad of opportunities that come our way. Prosperous business people and leaders have keen eyes for sporting multiple opportunities. They also train their minds to become capable of calculating opportunity costs. They make statistical efforts of analyzing opportunities, risks, liquidity, and balance sheets.
Opportunities manifest where market gaps occur and create demand for which capital has to be invested. Good opportunities generate profits when capital investments required to create supply are made. Some opportunities yield benefits in the short run while others take longer.
More importantly, some opportunities require quick investments, while some depreciate and expire much slower than others. Different opportunities yield different rewards from the same amount of capital investment.
- Liquidity and Balance Sheets
Liquidity refers to the ease of access to investment capital. Despite boasting a very rich and wealthy balance sheet, many business people numerously fail to exploit very rewarding and lucrative opportunities.
Good balance sheets often symbolize cash flows and vice versa. However, businesses with professional accountants balance the two concepts by investing in fast-moving assets for the sake of fast liquid capital generation. High liquidity reduces opportunity loss.
Risks represent the potential of an investment made on an opportunity yielding returns that do not sum up to the expected value. Investors should always prefer the options, which for a zero score of opportunity cost, present fewer risks.
Generally, opportunity cost is a forward-looking concept of economics. It requires critical thinking and ample research. Economists advise against making impulsive financial decisions. Therefore, as a budding investor, leader or aspiring financial legend, opportunity cost should be a calculation that you make every day of your life.
Opportunity Cost Formula
While opportunity costs are seldom categorized as positive or negative, its financial implications should be categorized. The mathematical calculation formula involves deducting the benefits accrued from the chosen alternative from the benefits that could have come from the most lucrative alternative.
If well calculated, opportunity cost should lead you to take the best alternative. In such a case the outcome is financially positive and should perhaps be indicated positively. Hypothetically, opportunity cost should be indicated negatively unless the best alternative is chosen.
Examples of How Opportunity Cost Is Applied
- Example 1
A man wins a lottery draw of one million dollars. His peers advise him to invest in either government bonds or in a promising stock. He consults a financial analyst who secludes a Treasury bond that earns five percent interest.
He then has to make a decision whether to invest in the bond or in the promising stock which is likely to earn him the same income. The opportunity cost tallies to zero in the event no risk manifests from both investments.
However, the stock investment presents a much bigger risk compared to the low-risk Treasury bond investment. The most suitable decisions only take risks over safe investments if the possible rewards are much higher.
- Example 2
An executive board has to re-invest ten thousand dollars in either expanding its production or in intensifying its marketing campaign. It audits its operations and determines that its production equals its demand. Expanding its market base would present an urgent need for expansion in production. Such a scenario would be easy to prove, and it attracts investors.
Expanding production would merely mean accumulating more assets than the company’s market share demands and ultimately hurting its bottom line. Preferring marketing growth to production growth leads to greater demand and thus the increase in its stock value. The opportunity cost of expanding the company’s production at the expense of its marketing would lead to an opportunity cost of its capital liquidity and further growth opportunity.
- Example 3
The opportunity cost of leaving your friend’s party to study for an examination is a common life challenge that many experienced. Opting to invest the same time to party at the expense of your studies would cost you a failure.
You have to choose between academic success and fun. However, you should understand that fun is a perishable good, while academic excellence is durable and empowering. The latter will educate you on how to achieve your financial goals on your own.
- Example 4
A person wishes to go to a premium movie theater. However, her movie budget won’t accommodate the snacks which she usually enjoys at regular theaters. The opportunity cost of visiting the premium movie theater consists of the foregone snacks.
- Example 5
A lady has to choose whether to train in audio production or to learn designer tailoring. The opportunity cost of either skill is the other foregone skill. The lady would have to consider other factors such as talent, required time, and market proficiency before making a money-wise decision.
As a result, the opportunity cost is a notion that can improve both your business and personal life. Feelings and hunches have no place when you find yourself at a crossroad. Pure data and analysis will show you the most profitable path for you. Have you ever applied the opportunity cost formula so far? Share your experience with us in the comment section below.