The concept of opportunity cost states that the cost of one item is the value of the next best option; in other words, the cost of one item is the value of the lost opportunity to do or consume something else. We're talking about a resource's "opportunity cost," they're referring to the value of the resource's next-highest-valued alternative usage.
Because humans must make choices, they will inevitably confront trade-offs in which they must give up what they want in order to obtain something they want more.
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What is the Opportunity Cost?
One of the most important ideas in economics is opportunity cost, which is present in many decision-making processes. The value of the next best alternative foregone is known as the opportunity cost. To put it another way, it is the expense of what one could have done instead.
The value of what you lose when you pick between two or more options is known as opportunity cost. It's a fundamental notion in both investing and life. When it comes to investing, opportunity cost refers to the amount of money you can lose if you buy one asset instead of another.
Opportunity costs can be either explicit or implicit, such as when you choose to spend your money on one thing rather than another. The latter will not harm your wallet, but it will deprive you of the opportunity to accomplish other things with your time or energy, which can have indirect financial consequences.
Warren Buffett, the famed value investor, offers another perspective on opportunity cost. "The actual dollar cost of any purchase isn't the real cost. It's the opportunity cost, or the worth of an investment you didn't make because you spent your money on something else."
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Opportunity Cost Estimation
At the time of a choice, opportunity cost cannot always be properly measured. Instead, the individual making the decision can only make an approximate estimate of the implications of various options, which means that incomplete knowledge can result in an opportunity cost that is only apparent in retrospect. This is especially important when the return is highly variable.
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What is the formula for calculating opportunity cost?
According to CFI, When computing the Net Present Value calculation in financial analysis, the opportunity cost is integrated into the present.
Net Present Value formula (source)
When faced with mutually exclusive options, the rule of thumb is to choose the project with the highest net present value (NPV). The opportunity costs can be added to the total costs incurred in C0 if the alternative project provides a single and immediate gain.
As a result, the decision criteria shifts from selecting the project with the highest net present value to pursuing the project if the net present value is larger than zero.
Financial analysts utilise financial modelling to assess the opportunity cost of various investment options. The analyst can analyse multiple projects and choose which is the most appealing by creating a DCF model in Excel.
Risk and Opportunity Cost
In economics, risk refers to the chance that the actual and predicted returns on an investment differ and that the investor loses some or all of his or her money. The potential that the rewards on a chosen investment will be lower than the returns on a forgone investment is known as opportunity cost.
The main distinction is that risk compares an investment's actual performance to its expected performance, whereas opportunity cost compares an investment's actual performance to the actual performance of another investment.
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What Can the Opportunity Cost Tell You?
When it comes to evaluating a company's capital structure, opportunity cost analysis is critical. When a company issues debt or equity capital, it incurs a cost to compensate lenders and shareholders for the risk of investment, but it also has an opportunity cost.
Loan payments, for example, cannot be invested in stocks or bonds, which give the possibility of earning an investment return. The corporation must evaluate whether expanding through debt leverage will yield more profits than it might through investing.
For Individual Investors: What Does It Mean?
If you're having problems grasping the concept, keep in mind that opportunity cost is intrinsically tied to the idea that almost every action involves a trade-off. You can't be in two locations at once since we live on a finite planet.
Explicit expenses are direct, out-of-pocket payments made by investors, such as the purchase of a stock or option, or the expenditure of funds to renovate a rental property. Wages, utilities, supplies, and rent are all examples of costs.
If you run a restaurant and want to add a new item to the menu that costs $30 in labour, food, energy, and water, your explicit cost is $30.
Your opportunity cost is the amount of money you could have saved if you hadn't decided to add the additional item to the menu. You might have donated $30 to charity, spent it on clothing for yourself, or put it in your retirement account to earn interest.
Implicit costs do not imply a monetary payment. They aren't direct costs to you; rather, they are the missed opportunities to earn money with your resources.
For example, if you have a second property that you use as a holiday home, the implicit cost is the rental income you could have earned if you leased it and got monthly rental checks when you weren't using it. You don't have to pay anything to use the vacation house yourself, but you will miss out on the possibility to earn money from it if you don't lease it.
When is it not a good idea to Use Opportunity Cost?
The concept of opportunity cost does not always work since comparing two choices quantitatively can be challenging. When there is a common unit of measure, such as money spent or time spent, it works well.
Because opportunity cost is not an accounting concept, it does not appear in a company's financial records. It is solely a concept of financial analysis.
Other Decision-Making Costs: Sunk Cost
Sunk costs are expenses that have already occurred and cannot be modified by current or future decisions. As a result, it's critical that this expense be overlooked during the decision-making process.
Assume that the company indicated above has made a $30 billion investment to begin operations. However, a drop in demand for oil products has resulted in a $50 billion revenue forecast. As a result, the project's earnings will have a net worth of $20 billion. The company also has the option of selling the land for $40 billion.
In this case, the decision would be to maintain production because the estimated revenue of $50 billion is still larger than the $40 billion earned from selling the land. The original investment of $30 billion has already been made and will not be changed regardless of whether the option is chosen.
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Bottom Line: Choosing Where to Invest Your Money
The idea behind opportunity cost is that your resources as a business owner are constantly restricted. That is, because you only have so much time, money, and experience, you won't be able to take advantage of every opportunity that comes your way.
If you chose one, you must inevitably abandon the others. They can't exist at the same time. Your opportunity cost is the value of those people.
In the grand scheme of things, opportunity cost is more about the decisions you make than it is about money or resources. It's all about remembering that one action or decision can prevent you from taking advantage of other possibilities.