The benefits one may have or might miss out on when choosing between two options
Opportunity cost can be broadly understood as the benefits one may have or might miss out on when choosing between two options. These costs can be overlooked, but they are present in every decision.
Again, the cost is the opportunity missed because of the decision chosen by an individual, investor, or businessman. You can properly evaluate the cost of a situation by accounting for every benefit from all options.
Doing this is desirable for a business or individual to arrive at optimal decisions. Therefore, understanding the cost of your decision as a business owner or investor is extremely important.
This definition can also be rephrased by saying that it is the loss incurred by choosing one alternative over another.
For example, suppose a business decides to cut its best consumer product out. In that case, the cost of that decision is the loss of sales and revenue from that product adjusted for the associated costs avoided.
The formula for benefit-cost can be calculated by subtracting the return on the forgone option from the return of the option chosen.
Opportunity cost = FO - CO
FO = Return of option forgone
CO = return of the option chosen
Opportunity cost is the benefits or potential gains foregone when choosing between two options in any decision-making process.
Evaluating the opportunity cost is crucial for arriving at optimal decisions for both businesses and individuals.
The opportunity cost can be calculated using the formula: Opportunity cost = Return of option forgone - Return of the option chosen.
Properly understanding the difference between opportunity cost and sunk cost is essential. Sunk cost refers to money already spent, while opportunity cost pertains to potential future returns lost due to a chosen alternative.
Combining risk analysis with opportunity cost assessment allows businesses and investors to make informed decisions that consider potential gains and risks effectively.
Benefit-cost can serve a significant role in determining a business’s capital structure.
1) For example, a company can either issue commercial bonds or equity investing. Both have different costs due to the characteristics of each option.
This cost is a forward-looking tool that can be used to evaluate the potential benefits of any given situation. Therefore, if an investor is trying to decide whether or not they should buy shares of a company, they can evaluate the possible future outcomes and make an educated decision.
When a firm tries to weigh the cost and benefits of issuing debt and stock, they consider monetary and non-monetary impacts both. However, whether one weighs the costs or not, the decision is still risky because it is based on an unknown future outcome. It exists because the world is.
2) For example, a company may not be able to invest in new equipment and a large amount of capital in securities. This happens because money is scarce, or in other words, wants are unlimited, but resources aren’t.
This can be applied to the example above: if a company wants to invest in new equipment and the stock market but they do not have the funds to do both, they go for the option yielding the most benefits.
The company may invest in securities hoping for a, but there is also a chance they may not make anything or lose money. Therefore, the company must analyze all available options and decide which carries the right risk to reward them.
In general, assessing the cost of two options can give you an idea of what result either decision may give you. The core result of what it provides an investor or business is what is given up when one option is chosen over the other.
Businesses must analyze both investments and produce the said cost when comparing the two options. Businesses will want to analyze the expected rate of return for both investments. Comparing the returns will give them the opportunity cost.
Suppose: A company has been given $50,000 to invest in one specific investment vehicle. The two vehicles they must choose between are government-backed bonds and LEAPs. The benefit-cost would be the profit lost by choosing one of them.
One good way to evaluate the opportunity that could be missed on either side of the decision is to make a pros and cons list and a list that shows the potential gain from each investment.
Let us suppose: One investment vehicle is equity securities, and the other is a government bond. Assuming the equity will give an expected twelve percent return and the government bond will give a nine percent return.
Remember, bonds are more stable than equity securities.
The cost of choosing equities over bonds is the larger risk that is inherited.
- If one chooses the bonds over the equities, the cost would be a three percent lower return. The equities would result in a $6,000 gain and the bonds a $4,500 gain.
- The rate of return can be calculated by subtracting the initial value from the current value, then dividing the difference by the current value.
- Since the company only has $50,000 to invest, it must decide whether to risk less and make less or risk more to make more.
The company not only wants to consider the first-year return, but it may also want to calculate returns and risks for the years following.
This is how an investor or business can find the cost of two options, compare them, then decide which option best fits their goals and needs.
In the simplest terms, the sunk cost is money already spent, while the benefit-cost is the possible return not earned in the future because money was parked in either of the available alternatives.
Sunk cost can also be called a retrospective cost. This is because it refers to an investment that has already occurred and can not be recovered. Some examples of sunk costs are marketing, research, and new software installation.
Sunk costs are not calculated or included in computations when making decisions about the future. This is because they are the opposite of relevant or future costs that haven’t been incurred yet.
Salaries paid would be considered a sunk cost assuming the company cannot get the money back.
Another example of a sunk cost would be the money spent on equipment or office assets that the company cannot get back.
In comparison, if these items were in consideration for the future, a company would likely consider the benefit-cost of the purchases before spending. For example, if a business was to put thought into purchasing equipment, then opportunity cost would come before sunk cost.
Companies would use the analysis of the opportunity missed when choosing between two options. However, once the equipment is purchased, the money spent becomes a sunk cost.
If a company buys $20,000 worth of stock, it cannot use that money to buy any other assets. Therefore, that investment can be considered a sunk cost. Although if they were to calculate the RoR on several investments, they could analyze the cost of all investments.
Here is a summary of the differences between opportunity cost and sunk cost:
|Opportunity Cost||Sunk Cost|
|Definition||The value of the next best alternative that one foregoes when making a decision.||Costs that have already been incurred and cannot be recovered.|
|Essence||Foregone benefit or potential.||Past expenditure that shouldn't influence future decisions.|
|Application||Used to evaluate the relative merit of different choices.||Often emerges in discussions to highlight past investments or decisions.|
|Decision Implication||Aids in ensuring the highest potential benefit is realized from choices.||Could lead to the "sunk cost fallacy", where past investments unduly influence future decisions.|
|Temporal Perspective||Forward-looking; considers future potential benefits.||Backward-looking; focuses on past expenses.|
|Example||Choosing between job offers and evaluating the foregone benefits of the declined one.||Spending on an advertising campaign that didn't yield expected results.|
Risk determines the chance that an outcome or investment’s actual gain differs from an expected outcome or return. This includes the chances of losing some or all of your investments. Risk compares the real performance of an investment against the anticipated performance.
Risk is everywhere, and everyone experiences it. It is in nearly every decision we make. However, businesses and investors try to keep their risk as low as possible while obtaining the highest return. Although risk and opportunity costs are different, they can be used together.
For example, suppose we use the above example about two different investment options: equities and bonds. First, one can take the risk of the investments and project the possible benefits. Then, one can make an educated decision using the risk and cost information.
Calculating the risk of an investment includes dividing the upside risk by the downside risk. The benefit-cost is only calculated to evaluate and compare the benefit of different choices.
For example, suppose one of the investments is much riskier than the other. Still, the potential profit is a thirty percent return, and the other investment is less risky, with a potential profit of ten percent. You can compare the risk analysis and benefit-cost to choose the best option.
Opportunity cost is the benefit sacrificed when choosing between two options.
This concept is essential in business and investing because it can help businesses and investors compare two decisions and the reward worth risking capital for.
Investors can use the benefit-cost formula to evaluate their options when comparing investments. The formula is the return forgone subtracted from the return of the option chosen.
Opportunity cost = FO - CO
For example, suppose an investor has two different investments, one producing a fifteen percent return and the other a ten percent return. The cost of choosing the fifteen percent return will be gaining ten percent on the other, and vice versa if the other investment is chosen.
Opportunity and sunk cost are completely different. Sunk cost is capital that has been spent and cannot be placed into other purchases or investments. At the same time, opportunity costs are the benefits that are let go when choosing an alternative option.
Using risk and opportunity costs together can help businesses and investors make educated decisions. For example, they can apply the risk involved in decisions with the opportunity cost and analyze their decision to attain the best risk to reward. As a result, they come out with the most profitable decisions.
Opportunity Cost FAQs
Yes, they should. It allows one to determine the cost of choosing one option over the other.
It is used by people many times in one day, and it can be used to make small or large decisions.
Yes, it would be considered negative if the outcome is not as good as the forgone decision.
Suppose a customer gives an investment firm money to gain the best return possible. Suppose one investment vehicle has a potential gain of 25%, and the other has a potential gain of 13%.
Theexample will be the 25% if the firm chooses the 13% gain. The other cost would be the 13% return on investment if the first vehicle did not perform better than 13%.
These costs are real costs the company incurs because they will not be able to get the opportunity to take the missed benefit again. However, this cost does not show up on financial or bank statements.
Researched and authored by Adam Bridges | LinkedIn
Reviewed and edited by Krupa Jatania | LinkedIn
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