Opportunity cost is defined as what you sacrifice when making one decision instead of another. This concept compares what you lose with what you earn based on your decision. The opportunity cost can be measured, but it can be difficult to quantify. Understanding the concept of opportunity cost can help you make informed decisions.
Calculating opportunity cost
1. Identify your different options.
When faced with a choice between two options, we need to calculate the potential returns for both. Since you can only choose one option, you lose the potential returns of the other. That loss is your opportunity cost.
- For example, imagine that your company has $ 100,000 in additional funds and you have to decide between investing in securities or buying new capital equipment.
- If you decide to invest in the securities, you may see a return on that investment. However, you lose any benefit you might have gained from buying new equipment.
- On the other hand, if you decide to buy new equipment, you can see a return on that investment in the form of an increase in sales. However, you lose any profit you might have gained by investing in securities.
2. Calculate the potential returns for each option.
Investigate each option and estimate the financial return on each. In the example above, imagine that the expected return on investment in the stock market is 12%. Your potential return is $ 12,000. New equipment, on the other hand, can result in a 10% increase in your profit margin. Your potential return for that investment would be $10,000.
3.Choose the best option.
Sometimes, the best option is not the most lucrative, especially in the short term. Decide which option is best for you based on your long-term goals, not just your potential return. The company in the example above may choose to invest the funds in the new equipment rather than in the stock market. Although investment in the stock market has a higher potential return in the short term, new equipment will allow them to increase efficiency and lower opportunity costs. This will have a long term impact on your profit margin.
4. Calculate the opportunity cost.
The opportunity cost is the difference between the most lucrative option and the chosen option. In the example above, the most profitable option is to invest in securities, which has a potential return of $12,000. However, the option the company chose was to invest in a new equipment to get a return of $10,000.
- The opportunity cost = the most lucrative option – the chosen option.
- $ 12,000 – $ 10,000 = $ 2,000
- The opportunity cost of choosing the purchase of new equipment is $ 2,000.
1.Evaluate business decisions
Establish the capital structure of your business. The capital structure is the way a company finances its operations and growth. It is a mixture of debt and equity of the company. Debt can be in the form of bonds issued or loans from financial institutions. Net equity may be in the form of retained shares or gains.
Companies should evaluate the opportunity cost when choosing between debt and equity.
If a company chooses to borrow money to finance an expansion, the money used to repay the principal and interest on the loan is not available to invest in stock.The company must evaluate the opportunity cost to see if the expansion made possible with the debt will generate sufficient long-term income to justify the decline in equity investments.
2. Evaluate non-financial resources.
The opportunity cost is often calculated to evaluate financial decisions. However, firms can use the opportunity cost to control their use of other resources, such as man-hours, time, or mechanical production. The opportunity cost can be defined with any resource that is limited in the company. Companies must make decisions about how to allocate these resources to different projects. The time spent on a project is taken away from something else.
- Imagine, for example, that a furniture company with 450 man-hours available per week uses 10 man-hours per chair to produce 45 chairs a week.
- They decide to produce 10 sofas a week that take 15 man-hours per couch. This will use 150 man-hours and produce 10 sofas.
- They will have 300 hours to produce chairs, which will result in 30 chairs. The opportunity cost of 10 sofas, therefore, is 15 chairs (45-30 = 15)}.
3. Determine what your time is worth if you are an entrepreneur.
If you are an entrepreneur, you will devote all your time to your new business. However, this is time that you could have dedicated to a different job. This is your opportunity cost. If you have a high income potential in a line of work, you must decide whether or not to open your new business.
For example, imagine that you are a chef who earns $ 23 an hour and you decide to leave your job to open your own restaurant. Before you earn a penny from the new business, you will spend time buying food, hiring staff, renting the building and opening the restaurant. In the long run, you will earn income, but the opportunity cost will be how much you would have earned by working on your old job all that time.
Evaluate personal decisions
1. Decide whether to hire a housekeeper or not.
Identify which household chores take up your time. Decide if the time you spend on these tasks means you do not have time to do anything else that you consider more valuable. Tasks such as washing and cleaning can interfere with work if you work hard from home. The time that you dedicate to the domestic chores also can hamper your ability to participate in other more pleasurable activities, like being with your children or dedicating yourself to a hobby.
Calculate the cost of financial opportunity. Imagine working from home and making $25 an hour. If you hire a housekeeper, you would have to pay $20 an hour. The opportunity cost of doing the housework yourself is $ 5 per hour Â ($ 25 – $ 20 = $ 5).
Calculate the opportunity cost over time. Imagine spending 5 hours every Saturday washing clothes, doing the shopping and cleaning. If a housekeeper came in once a week to clean and help wash clothes, you would only have to spend 3 hours on Saturday to finish washing clothes and make the purchase. The opportunity cost of doing household chores yourself is 2 hours.
2.Determine the true cost of going to college.
Imagine that you are going to pay $ 4,000 a year to attend a local college. The government will subsidize an additional $ 8,000 for your tuition. However, you should also consider the opportunity cost of not working while you are in college. Imagine you could make $ 20,000 a year in a job instead of going to college. This means that the true cost of a college year is tuition plus the opportunity cost of not working.
- Total tuition is the amount you pay ($ 4,000) plus the government grant ($8,000), which equals a total of $ 12,000.
- The opportunity cost of not working is $ 20,000.
- Therefore, the total cost of a college year is $12,000 + $ 20,000 = $ 32,000
Other opportunity costs associated with going to college include the value of four years of work experience in the real world, the value of time spent studying rather than other activities or the value of what you might have bought with money that you spent on tuition or interest that money could have earned if you had invested it.
However, consider the other side of the coin. The average weekly earnings are $400 higher for a person with a college degree than for a person who only has a high school diploma. If you decide not to go to college, the opportunity cost is the value of the increase in your future earnings.
3. Recognize opportunity costs in daily decisions.
Every time you make a decision, you give up something else. The opportunity cost is the value of the option you don’t choose. This value may refer to something personal, financial or environmental.
If you choose to buy a new car instead of a used one, the opportunity cost is the money you would have saved in the used car and how you could have used that money differently.
Imagine that you decide to spend your tax refund on a family vacation instead of saving or investing the money. The opportunity cost is the value of the interest in the savings account or the potential return on an investment. Opportunity costs are all around us. Now, you know how to calculate them.