how to compute opportunity cost

For example, a college graduate has paid for college and now may have outstanding debt. This college tuition is a sunk cost, since it’s been incurred and cannot be recovered. If the graduate decides to change career fields, any decision should factor in future costs to do so rather than costs that have already been incurred. So the opportunity cost of changing fields may include more tuition and training time, but also the cost of the job this is left behind (as well as the potential salary of a job in the new field).

Opportunity cost examples

how to compute opportunity cost

The opportunity cost of the 10 percent return is forgoing the 8 percent return. Inversely, the opportunity cost of the 8 percent return is the 10 percent return. Even if you select the 10 percent return – and therefore earn a better overall return – your opportunity cost is still the next best alternative. Economic profit, however, includes opportunity cost as an expense.

Evaluating Business Decisions

This article will show you how to calculate opportunity cost with a simple formula. We’ll walk through some opportunity cost examples and give you tips to apply them to your business. You’ll also learn how opportunity costs, sunk costs, and risks are different. Assume the expected return on investment (ROI) in the stock market is 10% over the next year, while the company estimates that the equipment update would generate an 8% return over the same period.

What Is an Example of Opportunity Cost in Investing?

It isn’t easy to define non-monetary factors like risk, time, skills, or effort. Assume that a business has $20,000 in available funds and must choose between investing the money in securities, which it expects to return 10% a year, or using it to purchase new machinery. No matter which option the business chooses, the potential profit that it gives up by not investing in the other option is the opportunity cost.

Final Thoughts: How to Calculate Opportunity Cost

When you have limited time, money, and resources, every business decision comes with an opportunity cost. Rest assured — you’ve made a good investment by reading this article. Learning how to calculate opportunity cost is an essential skill for all business owners.

  1. Put simply, opportunity cost is what a business owner misses out on when selecting one option over another.
  2. You could simply spend it now, such as on a spur-of-the-moment vacation, or invest it for a future trip.
  3. The difference between the future profits is the opportunity cost definition.
  4. Consider a young investor who decides to put $5,000 into bonds each year and dutifully does so for 50 years.

One certificate of deposit (CD) with a major bank offers an annual interest rate of 3.5% compounded monthly. Using an interest calculator, you determine that your savings would grow to $13,100.37 in five years, an increase of over $2,000. The trade-off, however, is that you can’t withdraw these funds for the entire five-year period.

Maybe you want an inexpensive sedan, but there’s admittedly more value in a larger SUV. An opportunity cost calculation could help you navigate your decision-making, as there will undoubtedly be sacrifices to make either way. The expected return on investment for Company A’s stock is 6% over the next year.

One of the most dramatic examples of opportunity cost is a 2010 exchange of 10,000 bitcoins for two large pizzas—at the time worth about $41. As of March 2024, expense definition those 10,000 bitcoins would be worth over $700 million. An opportunity cost of less than one doesn’t always mean you should make a different decision.

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