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Last Updated on April 13, 2022

Opportunity costs are expenses you pay when you choose one alternative option over all others. These costs may be financial but are not limited to and are necessary to consider for all business owners.

This article will give an in-depth analysis of what opportunity costs are, their applications in the real world, and how you can calculate them.

What Is an Opportunity Cost?

It is imperative for a business owner to make sacrifices. Time, money, and relationships are just some of the things that you may give up for the sake of running a successful business.

An opportunity cost is an opportunity or the opportunities that a person forfeits when they take a particular course of action.

For example, if a chain fast food restaurant serves Coke products, their opportunity cost is Pepsi products. Since the restaurant partnered with Coke, they cannot legally sell Pepsi as established in their contract.

Opportunity costs are used to calculate the advantages and disadvantages of the decision-making process. They can tell a lot about future gains, losses, and returns. In a nutshell, you’ll use them to calculate a business’s capital structure.

Why Are Opportunity Costs Used?

Companies mainly use opportunity costs to make critical business decisions. By weighing the risks and rewards of making alternative options, a business can choose the best course of action.

Doing this will help predict the working capital of a business by using potential debt, equity, and assets as variables. Knowing a company’s financial outlook can help formulate a business plan for the future and make adjustments as necessary.

Opportunity costs are also used in hindsight to see where the business would have been if it had taken a specific action in the past. It won’t help change the concurrent state of the company, but it will help calculate future opportunity costs and allow a higher degree of accuracy for future projections.

Calculating an Opportunity Cost

For investors and business owners, calculating opportunity cost usually estimates economic returns/losses. For that, there is a simple equation you can use:

Opportunity cost = (gains of the non-chosen option) – (gains of the chosen option)

When determining the gains of both options, you’ll likely have to make rough estimates based on historical performances and projected outcomes. This method is popular with investors who use it to calculate the most profitable stocks.

You can use this formula to calculate the cost of multiple opportunities, but it is most accurate as a two-variable function. Unless by choosing an option, you forgo various possibilities that you could have taken at once, you should calculate each opportunity cost individually.

Example of Opportunity Cost

Say you’re the owner of a supermarket. You can choose to source your chicken from organic-based farms and non-organic farms.

Organic chicken is more expensive, but certain customers are willing to pay more for it, and you can market it as healthy. On the other hand, non-organic chicken is cheaper and more people are likely to buy it.

After crunching the numbers, you expect a 2% increase in overall sales from selling organic chicken and a 5% increase from selling non-organic chicken.

If you choose to sell organic chicken, your opportunity cost would be 3%. This number is calculated by subtracting the unused option (non-organic chicken at 5%) from the used option (organic chicken at 2%).

How Do Investors Use Opportunity Cost?

Opportunity cost is utilized widely by investors to calculate potential returns from various stocks. They compare different companies’ yearly, quarterly, and monthly returns and use the opportunity cost formula to predict how the market will move.

It may be used in an attempt to generate a capital gain or as an indicator of when to or not to invest. The opportunity cost ultimately determines which company assets are most worth it to hold and which fall short.

The opportunity cost can also help investors determine how much they should invest in a specific stock. If the function shows low risks, it may prompt an investor to invest more capital volume.

Other Applications of Opportunity Cost

Since the opportunity cost formula is a very versatile function, it has a wide array of applications that haven’t been mentioned in this article. One such application would be calculating non-financial opportunity costs.

The equation is best suited for numerical variables but can be used to determine the benefits of business relationships, customer ratings, and company reception.

Of course, it’s not only businesses or investors who use opportunity costs, and just about anyone can use them. It’s a very straightforward yet versatile function that can aid buyers in making big purchases such as houses, cars, and tuition.

The opportunity cost formula is also practical for time management, and millions of people unknowingly use it every day. By consciously employing opportunity costs in daily life, an individual can immediately increase productivity and organization.

Limitations of Opportunity Cost

Perhaps the most significant limitation of opportunity costs is that businesses and investors usually base them on estimations and guesswork. Historical records can’t predict the future, and you’ll find that the formula isn’t always accurate.

Opportunity costs are suitable for speculation but not for calculating exact numbers.

There is also the issue of factors that cannot be represented with numerical data. Calculating the opportunity cost of elements that have more abstract values may hinder and obstruct the thought process.

The Bottom Line

Opportunity costs are crucial for businesses to determine since they can help formulate capital structure and map out the potential risks of making a specific choice. They’re also an essential part of the investing process because of their ability to project capital gain/loss potential.

Opportunity costs have a wide array of applications for business owners, investors, and in everyday life. Taking advantage of them can help determine a make-or-break decision and get an idea of where you or your business will stand financially.