What Is Opportunity Cost in Finance? Definition, Formula & Importance

What Is Opportunity Cost in Finance? Definition, Formula & Importance

In a financial sense, the opportunity cost of one decision is the financial return of its best alternative. 

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What Is Opportunity Cost?

As individuals, we make countless choices every day. We decide what to wear to work, where to eat lunch, who to see socially, and what to do with our free time. Due to factors like time and money, many of these choices are mutually exclusive, meaning that once we choose a particular option, we lose the opportunity to choose its alternative.

For instance, if your favorite baseball team and your favorite band are playing on the same day at the same time, you probably can’t attend both events—you have to weigh your options and try to choose the event that will benefit you the most.

If you choose to attend the concert, you might miss the only game in which your favorite baseball team’s star pitcher, during her last year before retirement, pitches a no-hitter. If you attend the baseball game, on the other hand, you might miss the last concert your favorite band plays in your city before their bassist and primary lyricist quits the band to start a solo project, and the band’s sound and musical direction change entirely.

In either case, your choice costs you, as it robs you of your opportunity to experience the benefits of its alternative. The benefits you would have received from this missed opportunity represent your opportunity cost for this decision. Opportunity cost is what a decision-maker sacrifices by choosing one alternative over another.

What Does Opportunity Cost Mean in Finance?

In finance, opportunity cost represents the financial benefit a decision maker relinquishes by selecting one option over another. For instance, if an investor has $100, and they invest it in Ford Motor Company, the potential returns their investment could have generated if put into a different stock (like General Motors or Volkswagon) represent their opportunity cost.

Any time a person, family, employee, investor, or business makes a financial decision, they incur an opportunity cost in the form of the financial benefit they would receive had they chosen the decision’s alternative.

In many situations, the opportunity cost associated with a particular decision isn’t exactly clear. If it was clear, the decision-making process would be easy. A decision’s opportunity cost often depends on how various factors, both known and unknown, may play out in the future, which is not always predictable.

How Is Opportunity Cost Calculated?

To calculate the financial opportunity cost of selecting one of two mutually exclusive options, simply subtract the expected return of option 1 from the expected return of option 2. Be sure to factor in any future costs associated with these options when estimating their respective returns.

If the difference between the two is positive, option 1 may be the most likely to be profitable. If the difference between the two is negative, option 2 may be the most profitable.

OC = (Expected Return of Option 1) – (Expected Return of Option 2)

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Opportunity Cost Formula

OC = (Expected Return of Option 1) – (Expected Return of Option 2)

The problem with this sort of calculation is that it relies on expected returns, which, in many cases, are nothing more than educated guesses. The only way to calculate opportunity cost accurately (when the returns of each option are not guaranteed) is in retrospect. Unfortunately, calculating opportunity cost in retrospect can’t change a decision that was already made.

Examples of Opportunity Cost in Finance

Just what opportunity cost looks like varies quite a bit from situation to situation. Below are a few examples of how financial opportunity cost can present itself in different contexts.

In Investing

Let’s say an investor got a $1,000 bonus from work and wanted to invest it in either a real estate ETF or an electric vehicle ETF. The investor might look at the returns of both ETFs over the last year and see that the real estate fund returned 15%, while the EV fund only returned 7%. For this reason, they might put the money from their bonus in the real estate fund.

Over the next year, however, let’s say some unexpected inflation occurs, and the Federal Reserve raises interest rates to combat it. This causes mortgage rates to go up, which negatively impacts housing demand, causing the real estate ETF to return only 4%.

The EV fund, on the other hand, benefits from an influx of cash from an infrastructure bill that prioritizes renewable energy, so it returns an unexpected 12%.

Since the investor chose the real estate fund, their $1,000 investment turns into $1,040. Had they chosen the EV fund, however, their investment would have been worth $1,120. The investor’s opportunity cost here is $80 because they would have made $80 more in capital gains had they chosen the electric vehicle fund.

In other words, even though the investor made money, their choice cost them $80 in money they could have made had they chosen the other option.

In Career Development

Most of us generate the bulk of our income by working, so career decisions can definitely come with financial opportunity cost. For example, a programmer might need to decide between accepting a job with decent pay now or rejecting the offer and spending some of their savings to take a course in order to learn a new programming language, a skill that could help them secure a higher-paying job in the future.

Calculating opportunity cost in this sort of situation is extremely difficult because there are so many possible eventualities. For instance, if the programmer accepts the job offer, their new employer might end up paying for them to take the course they were interested in during the evenings after work. Once the programmer finishes the course, their employer might raise their salary to compensate them for their new skill. If not, the programmer could seek higher-paying work elsewhere now that they are more qualified.

If this was how things played out, taking the job would definitely have been the better choice financially, as the programmer would not have had to spend any of their own money or miss out on income that could have been earned while taking the course.

On the other hand, the programmer might take the job only to be laid off in two years’ time when the company has to downsize due to lost market share and falling income. In this case, it likely would have been in the programmer’s advantage to take the course and then seek a job at a more successful software company.

The problem here is that there would be no way of knowing ahead of time which decision might end up playing out to the job seeker's financial advantage in the long term—there are simply too many unknowns. In cases like these, the best course of action is to gather as much information as possible and attempt to make an educated decision that balances financial security with the possibility of higher income.

In Business

Businesses have to make financial decisions all the time. Often, these decisions involve the use of capital. For instance, if a business has a spare $2 million, it could invest in hiring, acquisition of plants and equipment, or research and development. If successful, all of these endeavors could allow the business to increase its income in the long term.

On the other hand, the business could put this money in the stock market. If equities perform well, the business could generate a lot more cash to invest in its own operations down the line.

How companies allocate their money is referred to as capital structure, and capital structure decision-making is one of the most important determinants of how profitable a business is. For this reason, most large businesses invest a significant amount of time and money into making educated decisions about their capital structure, and these decisions are made largely via opportunity-cost analysis.

Opportunity Cost vs. Sunk Cost: What’s the Difference?

In a financial sense, the phrase “sunk cost” refers to money already spent. This money has been “sunk” into a project, and if that project hasn’t been as successful as planned, it can be tempting for a decision-maker to cling to the project due to the money they’ve already invested in it. This may not always be the best decision.

While sunk costs are already incurred, opportunity costs are not. Opportunity cost is a strictly forward-looking measure that does not take any past expenditures into account. It is common, however, for businesses, investors, and other decision-makers to focus too much on sunk costs when deciding whether to continue with a certain course of action as opposed to abandoning it for an alternative.

In reality, sunk costs should not be a deciding factor in financial decisions. Opportunity cost is more important, as future returns may vary, whereas sunk costs are set in stone. By continuing to invest in a project simply because money has already been spent on it, a decision-maker can miss out on the potential for higher returns that could be realized if this project or investment was abandoned in favor of something more lucrative.

In other words, money spent or lost remains spent or lost regardless of what one does in the future. Despite the psychological inclination to the contrary, there is no reason to continue to invest in something—be it a project, a stock, or a career path—simply because significant time and money have already been sunk into it.

Can Opportunity Cost Be Negative? Can It Be Zero?

Opportunity cost can be positive, negative, or zero. Using the formula above, a negative opportunity cost would indicate that the second option is likely to be more profitable than the first. An opportunity cost of zero would indicate that both options are likely to be equally profitable.

Why Is Opportunity Cost Important in Financial Decision-Making?

Opportunity cost analysis is important in financial decision-making because it allows the decision-maker to play out the potential financial results of each branch of a decision tree before making the decision.

While opportunity cost analysis is usually far from an exact science, evaluating and comparing the known future costs and returns (and attempting to guess at the unknown future costs and returns) of each option can provide the decision maker a more holistic view of their options and the potential outcomes each could generate. 

Provided by: The Street Retirement

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