When you’re making an investment, whether you’re a business or an individual, you want to make a decision that’s as informed as possible. Especially if you’re choosing between one investment and another, it’s key that you have enough data to perform due diligence on each option. Financial reports are an essential part of this process, but opportunity costs offer an effective tool that allows you to compare different investment outcomes. This article will explain how to work out opportunity cost and the benefits it can bring, starting with our opportunity cost definition.
Opportunity cost definition
Opportunity cost is a fundamental concept within economics and a useful calculation for anyone looking to compare the potential costs of two financial investments. The idea comes from the concept of scarcity. Wherever there are scarce resources, there are choices that need to be made as to how to use and distribute these resources in an optimum way.
Although the exact opportunity cost definition will change depending on the type of resources, the fundamental calculation involves comparing one choice to another. For example, if you choose to spend £30 on a meal out, then you cannot spend this money on birthday presents for your friends. In short, opportunity cost is the measuring of one choice against the next best alternative, otherwise known as the best forgone option.
Why use opportunity cost?
If you have multiple choices of where to invest your money, you’re going to want to compare the costs and benefits of each option before you make your final decision. Calculating the opportunity cost of each option compared to the others is a great way to inform your final choice. As well as helping you to identify the return on investment for each option, it can help you to compare the potential costs involved in each decision.
This is what makes calculating opportunity cost particularly useful for businesses looking to determine their capital structure. Although the actual rate of return is unknown, it can help businesses to determine whether leveraging their debt will be more profitable than making further investments. For example, any payments made towards business loans can’t be invested in the stock market or into the business itself (e.g., in new equipment or personnel). Calculating opportunity cost enables businesses to take both financial and non-financial considerations into account when determining an option’s profitability.
How to work out opportunity cost
The formula for working out the opportunity cost is as follows:
Opportunity Cost = Return on Best Forgone Option – Return on Chosen Option
For example, if you’re choosing between investing money into your business’s equipment or putting this money into the stock market, then you should take away the expected return from your equipment investment from the profits you’re expected to generate on the stock market.
When looking at opportunity costs, it’s important to take all possibilities into account. For example, if you’re thinking of investing in a high-return, high-risk set of stocks, then the potential return will be lower than the profits related to higher productivity from equipment investment.
Opportunity cost example
In real terms, an opportunity cost example may look something like this:
Option A involves investing in new equipment for your business. This is expected to add 5% onto the profitability of your business compared to 2% in a standard year. Option B requires investing in venture capital for a new organisation with a potential 10% annual return. The opportunity cost of choosing the equipment rather than investing the venture capital would be 10% minus 5%. This would mean by investing in the equipment, you would forgo the chance to earn a higher return of around 5%.
However, there’s also a balance of risk involved in this calculation. For example, if the organisation which you invest in folds within the first year, the return on your investment may be equal (0%) or even less. This would make investing in the equipment a safer option, even if the profitability of your business remains stable at 2%. Weighing up each of these options is key to using the opportunity cost calculation to full advantage. This way, you can compare each investment easily and ensure you’ve done due diligence on any business or individual investment.
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