An overview of Opportunity Costs and how they are calculated
In terms of the economy, the cost of any product or service is its opportunity cost. Usually, all human-made choices have alternatives based on scarce resources. With limited resources, people can’t buy everything they want due to limited income. The opportunity cost formula comes into play sure very often, considering our scarce resources.That’s why they have to make choices between different alternatives. As the law suggests, you can’t have all that you want. So, such scarcity forces each one of us to choose among better choices. Your choice lets you think of all those you forgo each time calls it the opportunity cost.An opportunity cost is a benefit or value you sacrifice by selecting one form of action over another.
The details regarding opportunity cost and how to calculate it using its formula will come in the subsequent sections of the article.
The opportunity cost is the cost that a company incurs when it foregoes any business investment option.
Calculating the opportunity cost formula is a helpful tool for businesses to use when making business decisions. It let the companies better understand if they were making better good choices. The opportunity cost usually works very well to accommodate comparative cost analysis given the alternatives under consideration. It can also determine whether the spending company has better and more viable business options that will result in a profitable deal.
It tells the story of what a business or individual misses out on when they opt for an alternative. “Economic cost”is also another term given to it while companies have limited resources to examine the best possible alternate in their interest. The opportunity cost formula will let anyone determine the most productive and profitable option. It’s the best way to determine the underlying risk and benefit attached to any investment decision in the long run.
Types of opportunity cost
Before getting into the calculation of the opportunity cost formula, let briefly define the types of opportunity cost.There are two types of opportunity costs available for business. One is the implicit opportunity cost, while the other is the explicit cost for the forgone opportunity
1. Explicit cost of opportunity
Explicit opportunity cost accounts for the tangible cost you can easily determine in terms of the dollar amount. Let say a business spends $30,000 on purchasing new computers for its employees. The opportunity cost would be that $30,000 amount that the company could invest in other alternates or miss out on a forgone opportunity with such computer purchase for employees.
2. The implicit cost of opportunity
Implicit costs are difficult to calculate because they account for intangible business costs. Implicit opportunity cost: time spent by business personnel on nonprofit work or services rendered for volunteer work will be accounted for implicit opportunity cost.
The opportunity cost formula never takes part in financial reports. Businesses do consider it while they make any investment in the multiple viable options of investment. The bottleneck technique is the most frequent cause of opportunity costs that companies usually use for product categories.
How can you cost investment opportunities?
The opportunity cost formula is not easy to determine as it has no simple solution for the particular situation. However, the opportunity cost formula is calculated based on the given equation. It lets you calculate the difference between the expected return and the actual return amongst chosen alternates. It is pretty helpful in two different scenarios. You can estimate the effects of future investment decisions or determine the gain or loss of past decision records.
You can use a quick and straightforward opportunity cost formula for any potential investment decision.
Opportunity cost=Return on option A -Return on option B
The greater you deal with real-time data like salaries, the average rate of return-on-investment, lifetime value of the customer, or competitors’ financial performance into consideration, the better will be its cost determination. It is more accurate to calculate opportunity cost as it occurs rather than predict it.
While making cost analyses for previous investments, the opportunity cost formula remains the same with a slight change in its label.
Opportunity cost=Return on forsaken investment-Return on selected investment
In consideration of the investment of a business, usually, business management puts forward the opportunity cost formula. However, it has certain limitations. It has a straightforward formula without any complication of variable inputs. However, it is difficult to determine the intangible factors of the opportunity cost formula,such as investment risk, time duration, skills, and effort typically employed in investment viability.
For instance, the two-to-three-week recruitment and selection process for a marketing manager is time you can’t consider for product features. So, rather than asking what is the best way to spend that amount of money, the best question for investment opportunity cost should be, “which option of investment gives you the comparative advantage?”
Two different scenarios for its illustration
The opportunity cost formula will let you enter the world of presumption while describing its differences. Additional alternates exhibit other platforms of investment portfolios. It is choosing among the best-given substitutes. The following is when a business encounters the opportunity cost in its initial stages or reformation process.
Let’s suppose the scenario of the opportunity cost formula. The retained earnings in the business saving account are worth $11,000. The financial manager intends to invest its retained earnings in a certificate of deposit with an interest rate of 3.5%. Over five years, the return on investment will grow to $13100.37, an increase of over $2000 over the initial investment. This investment trade-off suggests keeping the money in the bank for five years without making any free fund withdrawals or any transfer.
Another scenario entails the flexible investment in a cash management account (CMA) with an interest rate of 3 that compounds monthly. The investment would then grow to $12,777.78, an increase of $1,800. It provides a free fund transfer facility.
Let’s put both scenarios into the opportunity cost formula for investment evaluation.
Opportunity cost = investment in a certificate of deposit – investment in a cash management account
The decision based on the financial opportunity cost would suggest of investment of $322.59 in the ermining. Another factor of liquidity in the investment decision would change the viable option to choose the more flexible option with a free fund transfer facility. As the certificate of deposit would restrict your free-floating fund services for five.
Another example of investment opportunities or cost is investor interest in purchasing stocks in Company A or Company B.
The expected return on stock investment for company A is 6% over the next year period. The investment is secured without any short-term or long-term risk of loss due to stable industry performance. On the other hand, Company B has a greater stock return on investment with 10% than company A. it has industry regulation laws that have threatened its long-term investment feasibility. However, it’s not viable enough in the process to pass the regulation law.
The opportunity cost of investment = Company AInvestment– Company B Investment
Company A has a 4% lesser return opportunity, making company B more feasible for investment if anyone chooses to Company Abased on secured investment opportunity without any market risk on investment.Company B is a much riskier investment without assurance of the investment return.Therefore, the opportunity cost formula mainly describes its viability for investment options without making any deep considerations.