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Opportunity cost

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What is Opportunity cost?

Opportunity cost is the value of the next best alternative that must be forgone when a choice is made between two or more options. In other words, it represents the potential benefit lost by choosing one alternative over another, reflecting the fundamental economic principle of scarcity and trade-offs.

Key takeaways

1
Guiding principle for decision-making

Opportunity cost helps individuals and businesses make informed choices by weighing the benefits and drawbacks of different options.

2
Not recorded in financial statements

Opportunity cost is an internal, strategic consideration and is not reflected in accounting profit or external financial reports.

3
Explicit vs. implicit costs
  • Explicit costs: Out-of-pocket expenses, such as money spent on equipment or rent.
  • Implicit costs: The value of resources already owned, such as time or foregone income.

4
Simple calculation
  • Opportunity Cost = Return of Best Foregone Option – Return of Chosen Option.
  • Example: If investing in stocks could yield 10%, but you choose to reinvest in your business for an 8% return, your opportunity cost is 2%.

Why opportunity cost matters?

Considering opportunity costs enables businesses and individuals to allocate resources efficiently, maximizing overall benefits and minimizing missed opportunities. This analysis is essential for strategic planning, helping to avoid decisions that could result in lower returns or wasted resources. Additionally, it promotes a thorough evaluation of both tangible and intangible trade-offs, such as time, money, and utility, leading to more informed and balanced decision-making.

The opportunity cost calculation process

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1
Identify all alternatives

List all mutually exclusive options available for a decision.

2
Estimate expected returns or benefits

Quantify the potential gains (monetary or otherwise) for each option.

3
Apply the formula

Opportunity Cost = Return of Best Foregone Option – Return of Chosen Option.

4
Interpret the result

A higher opportunity cost means greater value is sacrificed by not choosing the next best alternative.

Impact on business and personal decisions

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Profitability: Ensures resources are used where they generate the highest returns

Strategic choices: Informs major investments, hiring, expansion, and product launches

Personal finance: Guides career, education, and spending decisions

Risk management: Helps avoid costly missed opportunities

Impact on financial statements

Real-world examples

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Case study: Business investment decision

A company has $20,000 to either invest in securities (expected return: 10% per year) or purchase new machinery (expected return: 8% per year). Choosing the machinery means the opportunity cost is 2% per year-the additional return the company could have earned by investing in securities instead.

Frequently asked questions about opportunity cost?

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No. Opportunity cost can include non-monetary factors such as time, convenience, or satisfaction.
It is a conceptual tool for decision-making, not an actual transaction or expense.
Yes. As circumstances and available options change, so do the opportunity costs associated with decisions.