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Opportunity Cost: Definition, Calculation Formula, and Examples

which one of these represents an opportunity cost?

Even Warren Buffett has to make decisions, and those with significantly less cash than the Oracle of Omaha have to think even harder about where they want to put those dollars. While the concept of opportunity cost applies to any decision, it becomes harder to quantify as you consider factors that can’t be assigned which one of these represents an opportunity cost? a dollar amount. One offers a conservative return but only requires you to tie up your cash for two years, while the other won’t allow you to touch your money for 10 years, but it will pay higher interest with slightly more risk. In this case, part of the opportunity cost will include the differences in liquidity.

which one of these represents an opportunity cost?

Companies try to weigh the costs and benefits of borrowing money vs. issuing stock, including both monetary and non-monetary considerations, to arrive at an optimal balance that minimizes opportunity costs. Because opportunity cost is a forward-looking consideration, the actual rate of return (RoR) for both options is unknown at that point, making this evaluation tricky in practice. Opportunity cost is a term that refers to the potential reward that you forgo when choosing one option over the next-best alternative.

How to calculate opportunity cost

Opportunity cost is the comparison of one economic choice to the next best choice. These comparisons often arise in finance and economics when trying to decide between investment options. The opportunity cost attempts to quantify the impact of choosing one investment over another.

Alternatively, the opportunity cost can be calculated with hindsight by comparing returns since the decision was made. Opportunity costs are a factor not only in decisions made by consumers but by many businesses, as well. Businesses will consider opportunity cost as they make decisions about production, time management, and capital allocation.

Economic profit versus accounting profit

The consideration of opportunity cost remains an important aspect of decision making, but it isn’t accurate until the choice has been made and you can look back to compare how the two investments performed. This opportunity cost would be lost if they decided https://www.bookstime.com/articles/direct-write-off-method to make the soles in-house. Remember, they already own the equipment to make them, but that is a sunk cost, as there is no way to recoup that cost anyway. The opportunity cost of choosing to invest in Company A versus Company B is 10% minus 6%.

  • For help making sense of how it specifically relates to investing, you may want to find a financial advisor using SmartAsset’s free financial advisor matching service.
  • From the traceability source of costs, sunk costs can be direct costs or indirect costs.
  • A sunk cost is money already spent at some point in the past, while opportunity cost is the potential returns not earned in the future on an investment because the money was invested elsewhere.
  • Companies try to weigh the costs and benefits of borrowing money vs. issuing stock, including both monetary and non-monetary considerations, to arrive at an optimal balance that minimizes opportunity costs.

Investors might use the historic returns on various types of investments in an attempt to forecast their likely returns. However, as the famous disclaimer goes, “Past performance is no guarantee of future results.” Consider a young investor who decides to put $5,000 into bonds each year and dutifully does so for 50 years. Assuming an average annual return of 2.5%, their portfolio at the end of that time would be worth nearly $500,000. Although this result might seem impressive, it is less so when you consider the investor’s opportunity cost. If, for example, they had instead invested half of their money in the stock market and received an average blended return of 5% a year, their portfolio would have been worth more than $1 million.

Investing Tips

If you spend your income on video games, you cannot spend it on movies. If you choose to marry one person, you give up the opportunity to marry anyone else. Even though opportunity costs include nonmonetary costs, we will often monetize opportunity costs, by translating these costs into dollar terms for comparison purposes. Monetizing opportunity costs is valuable, because it provides a means of comparison. It used to be that judges occasionally sentenced convicted defendants to “thirty days or thirty dollars,” letting the defendant choose the sentence.

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