Opportunity cost is a theoretical concept that measures the cost of what you don’t do when you have to choose any type.
This cost differs from an actual cost, also known as accounting cost, which occurs directly and quantitatively. Opportunity cost is based on a “qualitative cost” of what could be done.
The concept of opportunity cost in economics.
In economics, the opportunity cost is explained by the conflict of choice that an economic agent has in a scarcity scenario, that is, when one cannot have, at the same time, the objects of choice.
This concept explains that all agents in the economy make decisions that make the best possible benefit, in exchange for a lower cost.
Therefore, opportunity cost is also known as economic cost, since it is an opportunity that is no longer used .
The choice conflict is known as a trade- off , which translates to a choice situation where one thing is won and another is lost, and what is lost is the opportunity cost.
Examples of opportunity costs
Opportunity costs can be exemplified for any situation in which there is a trade- off :
- If a company carries out a renovation, it stops buying new equipment or machinery for its production line;
- When we buy a new television, we stop buying a musical instrument;
- For the government, the opportunity cost of expanding the defense program is also the amount it no longer invests in hospitals;
- The opportunity cost of work can be thought of as the benefit of having free time;
- In an investment, the opportunity cost is measured by the value that other investments return that it would be possible to do with the same amount.
How to Calculate Opportunity Cost
The opportunity cost, when it is possible to measure it, is calculated from the benefit that one would have with the option that was not chosen.
This calculation takes into account the benefit of the best alternative that had to be abandoned, either for an activity, but also, when buying a good, which becomes a cost for the one that was actually chosen.
Example of how to calculate opportunity cost
If a company buys $100,000 of sheet steel to produce cars, but has the option to resell this raw material for $130,000, the opportunity cost in production is exactly the latter value.
Opportunity cost, or economic cost, takes into account an “implicit cost”, which is precisely the benefit one would get from what is given up, in addition to the actual cost.
It is possible to calculate in a more elaborate way following a comparison between an activity A and another B, considering the benefit attributed to each, as follows:
Opportunity cost of A: benefit of B + [Actual cost A – Actual cost B]
Returning to the previous example, about the company that produces cars, we can consider production as activity A:
- Profit or income from the sale of automobiles: $200,000.00;
- Production costs: $120,000.00;
- Other costs: $30,000.00
And yet activity B with the benefit of selling steel sheets for $130,000.00 together at a cost of delivering them for $10,000.00. The calculation of the opportunity cost of production is calculated:
Opportunity cost of A: 130,000 + [(120,000 + 30,000) – (130,000 + 10,000)] = 130,000 + 10,000 = $140,000.00
And the opportunity cost of activity B:
Opportunity cost of B: 200,000 + [(130,000 + 10,000) – (120,000 + 30,000)] = 200,000 – 10,000 = $190,000.00
For this reason, the opportunity cost is higher for the company to stop producing, that is, if it chooses to sell sheet steel.
Investment opportunity cost
In the financial field, the opportunity cost is also considered when the investor can choose different types of investments, with different returns.
To determine the opportunity cost, it is possible to consider the rate of return of the investment that has not been realized, to calculate its present value.
The higher the rate of return of the other investment, the lower the value of the investment in question.
If investment A should return, at the end of its 2-year period, the value of $10,000.00 and there is an investment B with a rate of return of 4%, the updated value of A should be:
Present value of A: 10,000 / (1 + 4%)² = $9,245.56
If the return on investment B is higher, the present value of investment A will be even lower, since its opportunity cost is higher. See the example with the rate at 8%:
Present value of A: 10,000 / (1 + 8%)² = $8,573.39