Life involves a never-ending series of choices about finite resources – time, money, energy, materials – and each choice has its own opportunities and risks. In microeconomics, economists seeking to quantify the costs associated with decision-making utilize the concept of opportunity costs. For example, consider a college student’s short- and long-term opportunity costs of attending a party instead of studying for and passing a final exam.
Businesses, investors, consumers and everyone else can make suboptimal decisions. Opportunity costs arise from the value trade-offs of the unchosen next best alternative, the road not traveled. These are not accounting costs and don’t appear in any financial reports. Instead, economists use these costs to help business owners, managers and others make better decisions by considering alternate uses for resources.
What Is Opportunity Cost?
A simple opportunity cost definition from Oxford Learner’s Dictionaries is:
Opportunity cost is when you choose one option and thus lose the potential benefits of the other options.
Opportunity costs are a consequence of scarcity. You don’t have endless time and money to pursue each alternative. In other words, opportunity costs arise from mutually exclusive options. What you gain from one choice is at the expense of the benefits from alternative choices.
According to Penn State University, sunk costs are costs already incurred and cannot be recovered. They shouldn’t affect opportunity costs, which involve forward-looking decisions. However, sunk costs can indirectly play a part when decision-makers throw “good money after bad” rather than cut their losses on a bad decision.
How to Calculate Opportunity Cost
Opportunity costs are usually expressed in monetary terms. This metric relies on the concept of returns: how much you get back for the money, time and effort expended on a particular option.
Opportunity Cost Formula
The formula for calculating opportunity cost is:
Opportunity Cost = FO - CO
FO is the return on the best option not taken
CO is the return on the chosen option
Return is defined as (ending value - starting value) / starting value).
The OC formula is just the difference between the expected returns of each option. When the result is positive, the forgone opportunity would have had a higher return than the chosen one.
Example of Opportunity Cost
An executive’s stock options have just become vested. He must now choose one of two mutually exclusive actions. He can sell the options outright for $50,000 (the explicit cost) or convert them to 5,000 shares of his company’s stock at $10 per share.
The agreement states that if he converts the options, he must hold the shares for one full year before selling them. The shares currently trade for $12 each.
The executive decides to sell the options and invest the cash in bonds yielding a return of seven percent per year, or $3,500. This is the chosen option, or CO.
After one year, the stock was selling for $11/share, making this alternative worth $55,000. This is the foregone option, or FO. Had he converted the shares, his one-year return on this alternative would have been (($11-$10)/ $10), or 10 percent.
As it turned out, his opportunity cost was FO - CO = 10 percent - 7 percent = 3 percent.
Although he had an accounting profit of $3,500 from the bond interest, he would have had a $5,000 profit had he chosen to convert his options. Due to implicit costs, his economic loss was $5,000 - $3,500, or $1,500.
Why Does Opportunity Cost Matter?
The purpose of opportunity cost is to optimally ration scarce resources such that they will produce the best return. North Dakota State University explains it allows companies to make financial decisions regarding how they spend their capital and gives investors a way to determine where to put their money. In other words, it helps to eliminate the waste from a missed opportunity.
The role of risk is essential and complicates the determination of opportunity costs. In the case of the stock options, the executive would have been better off converting the stock options as long as the shares traded for more than $10.70, 7 percent more than the conversion price (i.e., equal to the return on the bonds). However, the stock market is risky, and the shares could have dropped well below his break-even price. His investment decision should have depended on his estimate of the stock’s price one year hence.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.