Opportunity cost

Opportunity cost refers to the potential benefit that an individual, investor, or business misses out on when choosing one alternative over another. While financial reports do not show opportunity cost, business owners can use it to make educated decisions when they have multiple options before them. Businesses weigh the potential benefit they could receive from making one decision over another. The concept of opportunity cost allows them to consider the potential missed opportunities of choosing one investment over another.

Definition

The term Opportunity cost comes from Microeconomics, and it refers to the cost of forgoing the next best alternative when making a decision. In other words, it is the benefit you could have received, but gave up, to take another course of action. Economists use opportunity cost to understand the efficiency of resource use and to ensure that scarce resources are used optimally.

Calculation

Opportunity cost does not require monetary payment. It is a comparison of the expected returns of options given up and the expected returns of the option chosen. The formula for calculating opportunity cost is:

Opportunity Cost = Return of Best Unchosen Option - Return of Chosen Option

Examples

In terms of Personal finance, consider the opportunity cost of deciding to spend money on an expensive car. The opportunity cost could be the benefit of investing that money, having it grow in the stock market, and eventually using it to fund your retirement.

In Business, the concept of opportunity cost is used in capital budgeting. Companies evaluate projects and decide where to allocate their resources (e.g., time, money, personnel). The opportunity cost of choosing one project over another is the forgone benefits of the other projects.

See also

• Cost
• Economics
• Microeconomics
• Personal finance
• Business

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