How to Calculate Opportunity Cost: 10 Steps with Pictures

Over five years, your $11,000 would grow to $12,777.78, an increase of nearly $1,800. Entrepreneurs need to figure out which actions to take to get the best return on their money so they can thrive how to calculate contribution per unit and not just survive. That action might mean hiring a marketing director for $80,000 per year or investing in marketing automation software for $3,000 per month, depending on the opportunity cost.

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Individuals also face decisions involving opportunity costs, even if the stakes are often smaller. Opportunity cost represents the potential benefits that a business, an investor, or an individual consumer misses out on when choosing one alternative over another. Ultimately, Tiller says, “considering the opportunity cost will help show the most profitable option to invest in, making the decision-making process easier for you.” Opportunity costs matter to investors because they are constantly selecting the best option among investments. If the organization opts to put its money into the income-producing securities instead of the new equipment, the opportunity cost will be 6% of the principal invested in the first year. In short, any trade-off you make between decisions can be considered part of an investment’s opportunity cost.

Formula for Calculating Opportunity Cost

Let’s say professional painters would have charged Larry $1,000 for the work. An investor calculates the opportunity cost by comparing the returns of two options. This can be done during the decision-making process by estimating future returns. Alternatively, the opportunity cost can be calculated with hindsight by comparing returns since the decision was made.

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For example, a person could spend $12 watching a matinee movie, or they could use it to buy lunch. If they opt for the former, they may not have money for the latter, and vice versa. On the other hand, “implicit costs may or may not have been incurred by forgoing a specific action,” says Castaneda. “Explicit https://www.quick-bookkeeping.net/ costs are those that are incurred when taking a specific course of action,” says Bob Castaneda, program director of Walden University’s College of Management of Technology. Opportunity costs can be easily overlooked because sometimes the benefits are unrealized, and therefore, hidden from view.

1. If they opt for the former, they may not have money for the latter, and vice versa.
2. Even if you select the 10 percent return – and therefore earn a better overall return – your opportunity cost is still the next best alternative.
3. For example, if you were to invest the entire amount in a safe, one-year certificate of deposit at 5%, you’d have $1,050 to play with next year at this time.
4. In this case, she can clearly measure her opportunity cost as 5% (8% – 3%).
5. In economics, everything comes at the cost of something else, so picking one option causes an individual or business to miss out on a different option.
6. But the funds you haven’t spent on office furniture yet would be considered an opportunity cost because you haven’t actually spent the money yet.

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Alternatively, if the business purchases a new machine, it will be able to increase its production. If the business goes with the securities option, its investment would theoretically gain $2,000 in the first year, $2,200 in the second, and $2,420 in the third. Opportunity cost can be applied to any kind of decision that involves a trade-off, whether that involves time, money or other resources. Let’s say you are deciding to invest in either Company A or Company B. You choose to invest in company A, which provides a return of 6% in one year. They represent the income or other benefits that could possibly have been generated had you made the alternative choice.

However, as the famous disclaimer goes, “Past performance is no guarantee of future results.” Opportunity cost is a term that refers to the potential reward that you forgo when choosing one option over the next-best alternative. The more you can inject real data — like market-rate salaries, average rate of return, customer lifetime value, and competitor financials https://www.quick-bookkeeping.net/absorption-costing-explained-with-pros-and-cons/ — into your projection, the better. In most cases, it’s more accurate to assess opportunity cost in hindsight than it is to predict it. Here’s how opportunity cost works in investing, plus the differences between opportunity cost, risk and sunk costs. When you have limited time, money, and resources, every business decision comes with an opportunity cost.

Using an interest calculator, you determine that your savings would grow to $13,100.37 in five years, an increase of over $2,000. The trade-off, however, is that you can’t withdraw these funds for the entire five-year period. Whether it’s an investment that didn’t go to plan or marketing software that didn’t improve lead quality, no one likes to see money disappear. Next, let’s look at the opportunity cost formula to see how entrepreneurs analyze each trade-off.

Trade-offs take place in any decision that requires forgoing one option for another. So, if you chose to invest in government bonds over high-risk stocks, there’s a trade-off in the decision what are accrued expenses and when are they recorded that you chose. Opportunity cost attempts to assign a specific figure to that trade-off. When considering two different securities, it is also important to take risk into account.

With that choice, the opportunity cost is 4%, meaning you would forgo the opportunity to earn an additional 4% per year on your funds. The expected return on investment for Company A’s stock is 6% over the next year. It’s in a stable industry environment with no short- or long-term threats. The purely financial opportunity cost of choosing the CD over the CMA is $322.59 in earnings. Although you’d earn more with a CD, you’d be locked out of your $11,000 and any earnings in the event of an emergency or financial downturn. On the other hand, a cash management account (CMA) offers an annual interest rate of 3%, compounded monthly.