“Learn where opportunity cost plays a role in business, finance, and personal perspective to manage resources and gains.”
Opportunity costs simply relates to the requirement of disposal of an item to acquire another; it is an elemental concept in economics and business analysis. In this article, the author focuses on a common tendency of individuals to make choices for the sake of short-term or material gain while neglecting the costs of making such a judgment. Opportunity costs are wider in this regard as it considers such a question as a much more comprehensive one, since it reveals the outcomes of different distinct options.
Opportunity cost, what it is, how to compute for it and ways on how it can be applied to real life are dealt with in this article.
You can visit our previous article on how to build a website if you are interested in website design.
What are opportunity costs?
Opportunity costs are the next best thing or value that is deemed to be lost whenever a specific choice is made rather than a different one. For this reason, this concept is important as it assists individuals and businesses to measure the hidden cost that comes with their decisions apart from the direct cost. Here is an example:
Suppose you possessed € 100 and wished to spend the entirety of that amount on a dinner at an expensive restaurant.
Thus, the monetary cost of this action is € 100, but the opportunity costs would be whatever is sacrificed for that dinner. As usual, you could have used that €100 for your holidays or, maybe, buy a mutual fund. If the option of the different fund was calculated according to its value, it offered 10percentile of yearly return. Thus, in one year, one would have amounted to €110.
Therefore, the opportunity cost of your dinner is the €10 that you were able to earn, but which you did not get, since you were at dinner! In case I wanted to save that amount for the holidays, the trade-off cost stands to be nil since there is no change.
The importance of opportunity cost
Opportunity costs have relevance in the following aspects:
- Business decisions: It assists freelancers and firms in determining whether a particular business move is beneficial to undertake.
- Personal finance: This will enable one to decide whether to invest his or her time and money in a particular way or not.
- The following are the policy objectives of the allocation of resources: Governments utilise it in an attempt to establish how different resource shortages should be handled.
Types of opportunity cost
Thus, various kinds of opportunity costs depend on the kind of decisions made:
- There are also costs which are not as vivid and do not always require money to be used, but they are also considered costs nevertheless. Examples of these are indirect or hidden cost expenses that are associated with, for example, the time spent and reduced satisfaction.
- Short-term and long-term opportunity costs:
Short term: Direct choices, for instance, to buy or not to buy an item.
Long-term: If investing today in education or further professional development, then the benefits of such investment will be received in the future.
- Economic and accounting opportunity costs:
Economics is concerned with the opportunity cost of the next best option that has not been taken, while accounting deals with determinable economic costs and revenue and mostly in monetary units.
How to calculate opportunity costs?
Oppurtunity cost is usually applied in the attempt to determine the worth of the forgone opportunity when sticking to another. It can also be used to recognise a risk of potential losses that may be latent or incurred in areas that are not re scrutinised.
Opportunity cost formula
Oppurtunity cost can be defined as the indirect cost which results from having made a certain choice for a certain value on the ground that every choice entails the sacrifice of the other. In other words, cost represents the loss or renunciation of the next best opportunity, and the formula for calculating opportunity cost is;
Opportunity Cost = Return of the Best Alternative Not Chosen- Return of the Chosen Alternative.
Where:
- Return on the opportunity cost: This shows the benefit or value that you would have got had you selected the option which was rejected.
- It is the gain you receive from the chosen scheme option, or in simple terms, what you are getting from the option that you have selected.
- This measurement can be done from a financial or non-financial perspective, depending on the nature of the decision.
Application of opportunity cost
Opportunity cost is quite handy in many fields as it helps in the management of resources to arrive at better decisions.
- This is especially helpful in business as it helps business organisations to compare the costs of investment opportunities and seek to ensure the best resource utilisation of value.
- In finance, it assists investors in the choice of the right investments or the right investment strategy, yielding profit in respect of the profit that can be obtained from other investment opportunities.
- They are used in personal contexts when one has to decide about division of time, how to spend money and when to engage in a task that will make now and when in a task that will be beneficial in the future.
- According to the policy makers and government planners, one of the main objectives of Opportunity cost is to determine the effects of measures regarding the allocation of public resources for the achievement of maximum social and economic results.
In all these contexts, the understanding of the concept of opportunity cost enables one to come up with better and more objective decisions in the allocation of scarce resources towards the most important objectives.
Practical examples of opportunity cost application
To explain the situation in more detail about how opportunity cost is used, we will provide a real-life everyday example, both in the financial and personal aspects.
- Financial calculation example
If a firm is faced with a choice, it must determine whether it should invest in a new product or revamp an existing product.
Option A: Investment in a new product, and the amount that should be earned annually is expected to be € 50,000.
Option B: Improve the existing product line, with an expected annual return of €45,000.
When choosing between the two options, the company should evaluate the opportunity cost of Option B as equal to:
Opportunity Cost = €50,000 (Option A) − €45,000 (Option B) = €5,000
This means the company would lose the potential of pulling an extra €5,000 under Option B as compared to Option A.
Time Example
Suppose one has a weekend having spare time and two options.
Option A: Work overtime and get €200 by the end of the weekend.
Option B: Attend a personal development course that could increase your future salary by €1,000 per year.
- Now, let us observe the advantages that are to be expected in each of the options above:
- Option A: Working extra hours.
Immediate Benefit: €200.
Immission costs: €800 that you would have missed in future earnings that could have been made if you attended the course.
Opportunity Costs = €1,000 – €200 = €800
- Option B: Attending the course.
Future Benefit: Additional €1,000 annually.
Disbenefit: Loss of €200 of immediate salary but gain of €800 net revenue.
\text{Opportunity Costs} = €200 – €1,000 = – €800. This is expressed in the form of a negative sign in the cell that follows the row; this means that the value of the benefit of the other choice is less than that of the chosen choice, and thus the decision made was correct.
Limitations of opportunity costs
On the other hand, has its limitations: The tool is quite helpful to study and analyse the relationship between variables due to the following reasons. Some main ones include:
- Lack of measurability: Some lost opportunities are hard to express numerically; this is especially so when it comes to non-material aspects, such as personal satisfaction or social responsibility by a firm.
- Imperfections of the rational person: The much-used concept is based on the idea of rational agents, but this is not true since sometimes human beings and businesses may make irrational decisions due to a hold-up in a particular line of thought, lack of information, or due to impulse.
- External factors: Fluctuations in the market and any other factors that may change when the concept of opportunity costs is being worked out.
Conclusion
Thus, it could be stated that opportunity costs is indeed beneficial for decision making, whether in the individual or business domain. Tradeoffs are methodical in that they help decision makers visualise what is lost when going for a particular decision instead of the other, hence, more decisions with more thinking behind them. If properly implemented, the idea described in this case can be useful in decreasing the levels of difficulty and competition faced by an organisation when making decisions in the context of the modern world.
