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How To Use The Opportunity Cost Formula

The document explains the opportunity cost formula, which helps individuals and businesses evaluate the potential benefits lost when choosing one investment over another. It outlines how to calculate opportunity cost, provides examples, and compares opportunity cost with sunk costs and risk. Understanding opportunity cost can enhance decision-making and resource allocation for better financial outcomes.

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Rakhi Dawar
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12 views7 pages

How To Use The Opportunity Cost Formula

The document explains the opportunity cost formula, which helps individuals and businesses evaluate the potential benefits lost when choosing one investment over another. It outlines how to calculate opportunity cost, provides examples, and compares opportunity cost with sunk costs and risk. Understanding opportunity cost can enhance decision-making and resource allocation for better financial outcomes.

Uploaded by

Rakhi Dawar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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How To Use the Opportunity Cost Formula

(With an Example and Comparisons)


Written by
Indeed Editorial Team

Updated August 16, 2024

Opportunity cost is a common calculation that many people use to plan for
better potential financial success. Understanding opportunity cost can help
you identify potential uses of various resources, helping improve your
decision-making when faced with two choices. In this article, we explain the
opportunity cost formula and how to use it, including an example.
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What is the opportunity cost formula?


Opportunity cost calculates the benefits you could lose if you choose one
option instead of another. To calculate opportunity cost, you estimate the
costs and benefits that every investment option could generate and then
compare them to choose the most profitable investment.The opportunity cost
formula is:Opportunity cost = FO - COFO is the return on foregone option,
while CO is the return on chosen option.For example, a company has the
option of either investing in a new market or expanding in an existing niche.
Investing in the new market will provide bigger customer segments and is
expected to generate a 20% return on investment over the next two years.
However, expanding in the existing niche will consolidate the position and
generate a 16% return on investment.The opportunity cost of choosing the
expansion of an existing market over the new market is 16% - 20%. This
means that the company would lose a 4% return on investment by not
investing in the new market.Read more: Opportunity Cost: Definition and
Example

What can an opportunity cost calculation tell you?


Opportunity cost can help you with the following:

Estimate lost opportunities

The key information you can get from an opportunity cost calculation is the
loss of opportunity. It helps you see the real-life consequences of choosing
one of two options. For example, calculating the opportunity cost of investing
in new machinery instead of upgrading old machinery can help you identify
the potential gains of your investment. Since older machinery might be more
susceptible to breaking down, it could make more financial sense to buy new
machinery. Being able to identify these opportunities allows for more
sensible decision-making to maximize resources.

Identify the relative cost of investment opportunities

Another advantage of opportunity cost calculation is that it helps you compare


the relative costs of alternative investments and the potential benefits you can
get from each option. This information allows you to choose an investment
that offers the best benefit for you.For instance, a business is considering
buying two new programmable sewing machines or five secondhand non-
programmable alternatives for the same price. After considering the current
and potential orders, the business decides that the five old machines are
better because they can increase production and save training time.

Compare the potential profitability of investments

Opportunity cost calculations can help you estimate the potential profitability
of alternative investments. For instance, a business wants to invest in new
equipment or securities. Calculating the opportunity cost of both investments
can show planners what the business could lose by choosing either of the two
options.

Provide insights about a company's capital structure

Opportunity cost calculations can also provide insights about a company's


capital structure. For instance, a company might be planning to invest in one
of two ventures. The potential returns on investment from either option can
affect the company's debt and equity in the future and ultimately affect its
capital structure.Related: How to Calculate Opportunity Cost: Steps and
Examples
Opportunity cost vs. sunk cost
Here are some of the differences between opportunity cost and sunk cost:

Opportunity costs

Opportunity costs involve the potential of losing or gaining money or another


benefit. They do not involve any actual cash or investment. It is important to
consider opportunity costs when you need to choose between two investment
options. That way, you can estimate the potential loss or gain from investing in
alternative options before committing resources. For example, you may want
to determine the opportunity costs of two job offers by comparing the salary,
benefits, commute time and other factors important to you.

Sunk costs

Sunk costs are costs already incurred that can't be recovered. An example of
sunk costs is the money a company used to complete market research before
setting up a new division. The money spent to invest in new machinery before
rolling out a new line of product is also a sunk cost. These funds are already
spent, and the company may or may not make the projected profit from the
new product line or new division.Related: Incremental Analysis: What It Is
and How to Calculate It

Opportunity cost vs. risk


Risk describes the chances that an investment's actual gains will differ from
the projected outcome or returns. It estimates the possibility of losing part or
all of the initial investment into a project. Opportunity cost shows the foregone
returns of choosing an investment over a similar alternative.Opportunity cost
compares the actual performance of an investment option against the actual
performance of an alternative investment. However, risk compares the actual
performance of an investment against its projected performance. Both risk
and opportunity cost are important for making investment decisions.The risk
associated with an investment affects its returns. To get the best results from
an opportunity cost calculation for two competing investments, it is essential to
know the risk associated with the investments. Therefore, it is important to
understand the variables for measuring risk to get a clear picture of the factors
that can affect returns.Related: Four Examples of Sunk Cost
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Opportunity cost calculation example


Here is an example of how to calculate opportunity costs:Bellingway Inc.
wants to invest $100,000 in a new branch office to better serve customers in a
fast-growing state. The company could also invest the same amount to install
new high-tech equipment at its current branch to enable customers to self-
serve, reducing the number of staff and overhead costs and improving
customer experience.The upgrade is expected to deliver a 10% return on
investment. However, the new branch is projected to return 15% within the
same period. Bellingway uses the opportunity cost formula to make a
decision:Opportunity cost (OC) = FO - COOC = 10% - 15% = -5%The result
shows that the company could earn 5% less if it invests in an upgrade of its
existing branch instead of a new branch.
 
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