Example For Opportunity Cost - Overview

By Sean Stevenson – Latest Revision January 26th, 2021

What Is Opportunity Cost?

Opportunity cost is the core value of a product or system when compared to another.  The best choice will be the one which affords the most opportunity, or which offers the highest rate of return. 

For example, if we assess the performance of two separate investment portfolios, we will naturally choose the highest return available.  This would be reflected in the opportunity cost analysis, which would compare the two investments to find which was the better performer overall. 

This means that we are taking the better option in terms of the opportunity cost that is being afforded to us.  

Opportunity cost represents a key concept in many economical considerations.  It is often used to determine the best course of action for a business model or an investment strategy.

 Investors make use of the opportunity cost to determine which investment appears more stable or more successful over a given time period.

Due to its hidden nature, opportunity cost can often be misunderstood or ignored entirely.  This is a direct result of poor planning procedures.  

By applying careful due diligence and recognizing the importance of opportunity cost, optimal outcomes can be fully realized.  Opportunity cost should always be considered before embarking on a new project.

A sound decision-making model will always take into consideration the opportunity cost.  

As a means of measuring different economical options, it is certainly a sound methodology to make use of.  Any modern business or investment practice can benefit greatly from the insights provided by an opportunity cost comparison.

Example

Two separate investments are being considered. 

One of these investments has an average annual return of 16% exactly.  The other investment trails behind at about 11% annual returns.

Example For Opportunity Cost

Depicted above are two separate examples of opportunity cost.  These investment opportunities are represented with their annual rates of return (by % of ROI).  Using the opportunity cost comparison method, we can easily differentiate the two. 

PRO TIP:  While this example of opportunity cost may seem inherently obvious, it often isn’t in practice. 

In reality, many individuals and businesses fail to take the time to thoroughly research the options available to them in their day-to-day lives.

In short, they are ignoring the opportunity cost aspect of their decision-making process.  Important elements go unnoticed as a direct result.  This leaves huge gaps in actionable knowledge, and greatly increases the likelihood of errors being made.

The opportunity cost difference between these two options is 5%, which represents the forgone benefit of choosing one over the other.  This means that the 16% return on investment -annualized- is a significantly better option in comparison to its 11% alternative.

Key Takeaways

  • Opportunity cost is a valuation system that allows for different options to be fully assessed.  This is based on current market valuations.  To properly apply this metric, it must be carefully considered against a wide range of options.  This will allow for the best value to be chosen above the others.
  • The forgone benefit represents the amount that would be lost if the lesser option were chosen over the more prominent opportunity available.
  • The use of the opportunity cost method allows for better decision-making in business or during investment. 
  • Many examples of opportunity cost are often used in economical thinking.  The more value present in a given situation, the better the opportunity cost will appear overall.
  • Financial reports do not list comparative examples of opportunity costs.  It is up to investors to carefully research and differentiate between multiple opportunities as they become available.

How To Calculate Opportunity Cost

As noted above, the opportunity cost formula is not complicated.  In fact, it will look something like this:

Opportunity Cost = Ideal Opportunity (IO) – Current Opportunity (CO)

Using the basic math equation above, we can separate two “costs” and find the difference in their ratios. 

Where:

IO = 11 and CO = 8

Opportunity Cost = 11 – 8

                                = 3

This means that the ideal opportunity available, outweighs the current opportunity by a factor of 3.  Whether this were a percentile (as in investments) or a dollar figure (as in a product being sold) would have to be determined by those using the formula.

In either instance, we can easily deduce that the ideal option available is significantly better than the current opportunity.  It is likely advisable therefore, to pursue this better option. 

If this were a business model comparison, the only mitigating circumstance might be the costs involved to make the transition.  

Key Takeaways

  • Using the formula for opportunity cost is a way of calculating the difference between available options. 
  • The difference will represent the numerical disparity between an ideal option and an existing option. 
  • This result will give you a better insight as to which option is more desirable. 
  • It can be used to compare products, services, or investment opportunities.  Many examples of opportunity cost can be understood by the different levels of analysis taking place.  Use these as a reference for your own comparisons!
  • While basic due diligence may seem simple, most people do not exercise it with regularity.  For best results, always look at your own opportunity costs.  Continuously reviewing them will ensure you get optimal results over the long term.

Opportunity Cost For Individuals

For any individual, the use of opportunity cost methodology can help to clarify a given thought process or idea.

By comparing different structures, capabilities, or even decisions, we can better understand where we sit, relative to where we might go in the future.

An excellent example of the use of opportunity cost for individuals, is the idea of developing a side business while working a full-time position.  This is something many of us face in our day-to-day lives.  We badly wish to have our own enterprise, where we are our own boss -answerable only to our ambitions as individuals. 

Unfortunately, the opportunity to build a side business can be costly.  This is where a careful consideration and weighing of options can occur.

Example

Terry enjoys his full-time position as a software developer.  However, he is still a junior in his career and feels he must strike out on his own to make more money in the short-term. 

To this end, Terry decides he would like to start his own business.  His practice would include coding software on-demand for clients.  He is diligent in his planning and has even considered the starting costs that would be involved.

However, when Terry looks at the opportunity cost, he realizes that he would have to turn down overtime -and overtime pay- in favor of building his business.  This would mean he would be sacrificing guaranteed monetary gains, in favor of hopefully building a profitable enterprise over time.

Rather than lose his much-needed overtime pay, Terry foregoes his initial plan.   As a compromise, he decides to only work on the business when he has personal time off.  

In this way, Terry has compromised to favor the optimal opportunity cost.  Albeit, while sacrificing the development of his personal project, he at least won’t be missing out on the overtime pay that would help him financially.

Opportunity Cost and Business Structure

Opportunity cost can offer key insights for any enterprise or business model.

For a public company, issuing dividends or equity to compensate investors carries an opportunity cost to its operations.  In essence, funds used elsewhere, cannot be refunded to serve the interest of further building up the existing business.  They must instead be accounted for as “dead money” that has served a different purpose.

While often difficult, offering incentives for investors is a necessity in order to attract additional capital.

Deducing the best use of funds for either expansion or the issuing of stock, can be discovered by focusing on the opportunity cost for each.

Example

A company purchases new equipment and proves successful overtime in its ventures.  This equipment was procured through the procurement of funds from outside sources.

Over time, as more profits are realized, the company wishes to maintain interest among investors as an effective vehicle for their time and capital.  The company recognizes its growth has and will continue to be, a product of its dedicated investor community. 

To this end of keeping its investors happy, the company decides to issue a healthy dividend for those who choose to purchase -and own- its stock.

This monetary decision represents a planning model that came from opportunity cost.  The company recognized the inherent importance of its investors and made a decision that will help maintain its reputation among existing shareholders. 

It will also encourage further investment over time by new prospective investors who learn of the company’s reputable practices.

As the company further expands, it may even consider buying back its own shares.  For now, however, it requires the continued support of its investor community.

Opportunity Cost and Investing

Analyzing different portfolios, investments, and opportunities, can often point to the highest yield percentages available in terms of investment return. 

While past performance is never an assurance of future profit, it can certainly give important clues as to existing market trends.

Assessing the opportunity costs associated with different funds or securities can grant key insights.  The advantages or disadvantages of each will become readily apparent by applying meticulous scrutiny.

Example

Example For Opportunity Cost

Investment A is an index fund that offers greater security, given the diversity of its portfolio.  This index fund has enjoyed an average return of 10% over the course of its 20-year existence.  Investment B is a single technology stock that has heavily outperformed the market.  While some analysts claim it is slowing in terms of its impressive momentum, various sources are reporting interesting developments that may propel it along even further than originally expected.  Its returns are 35% annually over the past 5 years.

Putting It All Together

The opportunity cost in this instance would heavily favor investment B. 

Should we use the opportunity cost formula, we can quickly determine that an additional 25% will be made in annual returns by our choosing investment B.

However, investment A is certainly the “safer” option in the long term because it is an index fund.   This means that it offers a diversified portfolio of securities to hedge against the inherent risk of the markets.  

A young investor with a lengthy time horizon would likely favor investment B for its large annual returns.  However, a more conservative or elderly investor, would be more likely to favor investment A for its diversification and stability.

Key Takeaways

  • Opportunity cost can deliver a quick assessment of returns on an investment.
  • Opportunity cost can also create context for the advantages and disadvantages inherent in a given scenario. 
  • Using different examples of opportunity cost to weigh various options can provide a clearer context than simply taking things at “face value.”

Opportunity Cost When Compared To Sunk Cost

Opportunity cost represents potential earnings that have not yet been realized.  Whereas sunk cost addresses the amount of money already spent.

A sunk cost does not necessarily mean the money is forever lost, however. 

If 100 shares were purchased at $10.00 a piece, then the sunk cost would be $1,000.  This would mean that while the shares are still existent (and may even be appreciating in value), the amount spent has already been paid, and is no longer in the hands of the investor.

In such an instance, the opportunity cost would analyze the shares purchased, and consider if there were better options that could have been exercised using the same $1,000.  This where a comparison of other companies and their share structures could be considered.

For accountants, a sunk cost represents the expenditure of the business they serve.  Whether they have been hired on full-time, or are simply analyzing the books, an accountant will take a tally of all sunk costs to develop a better understanding of a company’s liabilities.  The opportunity cost herein, would involve analyzing expected returns on any investments made.  If a return could be higher elsewhere, then the accountant would likely cite this possibility to his or her employers.

Whether in terms of investment returns or business expenses, a rational investment will always take into consideration the opportunity cost involved. 

If it is at all possible, the money should be diverted elsewhere, into higher returns on investment.  Moreover, this process must be continual, in order to optimize the percentages of return over time.

Opportunity Cost And Risk Assessment

In any business or investment opportunity, the risk involved is always something that must be carefully considered.

The possibility of losing some or all of the capital invested is a dire concern to any prospective investor.  In this instance, the opportunity cost would assess the ideal returns available on the market.  This means that if funds are currently invested in a weaker ROI when compared to other securities, then the amounts invested must be reconsidered.

Selling out of one stock that is underperforming in order to purchase a higher rate of return from another stock, is considered common practice in the marketplace.  This is where the opportunity cost excels at providing value.  It allows for objective consideration of percentile returns, as compared with the availability of different securities on the market. 

If one sector or stock is outperforming all of the others, then an objective opportunity cost comparison will reveal this new trend.

Example

The return on investment of a stock has dwindled recently over time.  Its current return percentile has sunken to 4%. 

Another stock has risen lately as a top performer.  Its returns have exceeded 16% on an annual basis, and it has proven itself a steady benchmark of its industry.

The investor analyzes these two stocks -amongst many others- and decides to reinvest into the top performer.  The difference of 12% (based on his opportunity cost analysis) reinforced his decision-making process to proceed with the new investment opportunity.

Opportunity Cost For Beginners

Most day-to-day decisions are based on emotionality.  People are often driven by simple urges and needs, which is perfectly normal in practice.

However, to get the most out of your own situation, it is advisable to research meticulously beforehand. 

Whether you are considering starting your own business, purchasing your first home, or even having children with your spouse, it is highly advisable to weigh the pros and cons carefully.  This will help you understand the opportunity cost associated with your decision.  Always challenge your own thought process to ensure you are “ready” for that next step. 

In committing to planning in this way, you will be making certain that your own decisions best reflect what it is you want out of life.  Lost opportunities are often regretted by those who realize they wanted them far too late.  Avoid this mistake by using an objective and unbiased opportunity cost analysis.

Example

In finding what we really need, a key component to consider is the waste involved.  If you purchase the latest car instead of a used one, how much additional money would you have wasted, as opposed to reinvesting it elsewhere?

Moreover, if you choose to eat out every single day, how much will that add up to in a year?  Where could you have spent that money more proficiently to help you build a better future?

In a single year, there are 365 days.  Consider how paying $10.00 on unnecessary food can easily add up to $3,650.00 in that same time frame! 

Planning for the longer term -in this way- should be a key component of your opportunity cost analysis.  Think of it as your own due diligence to help keep you on the right track.  You’ll surely thank your younger self down the road for remaining diligent over time.

Key Takeaways

  • Opportunity cost can accurately assesses the wasted opportunity in our daily lives.
  • Many examples of opportunity cost can clearly depict the disparity in value of poor decision-making.
  • Purchasing cheaper and more practical options is a great way of using opportunity cost to your advantage. 
  • Reinvesting additional income or money saved, can make a huge difference in anyone’s financial picture.
  • In a single year, try to find ways to save money.  For added motivation, calculate how much money over the course of a year this will save you.

Conclusion

Using the opportunity cost can help deliver important information.  For any business, investor, or individual effort, it can offer huge value.

If you want to better understand and categorize the opportunities available to you, this method can provide you with an excellent framework.  Moreover, it’s free!

Always try to consider how to advance your own cause and security.  By making use of the opportunity cost, you can safeguard your own interests while simultaneously building a better tomorrow on your own terms.

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