By: First Union | Date:
What are Opportunity Costs?
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Simply put, you might think about opportunity cost as a tradeoff. Essentially when consumers, investors even businesses make a decision in which they have to choose one thing over another, the impact of their choice and the loss of the foregone alternative are opportunity costs. In other words, by choosing one thing over another, the cost of that choice becomes the opportunity cost. This is the case for basically any choice we make. If a business opts to present one product to the public over another, that unchosen product and potential profit equate to the opportunity cost of their choice. Same with investors, by investing in one entity over another, the alternative not chosen and consequent cost therein is the opportunity cost.
Understanding Opportunity Costs
Returning to the example of an investor…They are often faced with choices regarding where to invest their money to ensure maximum return on that investment. When they do finally decide which investment to pursue, the investment not chosen becomes their opportunity cost.
We can also look at opportunity cost as it relates to businesses and the decisions they make. Daily, business owners must make decisions regarding where to allocate money, how to most efficiently manage time, and what type of production choices they are going to implement. To this end, the alternatives not pursued will be the business's opportunity costs. Again, we come back to this idea of a tradeoff. With any decision, you are going to encounter some form of tradeoff. Let's say as an investor you choose a mutual fund over investing in a high-stakes stock. The cost of choosing to invest in the fund versus the stock represents your opportunity cost.
Calculating Opportunity Costs
There is a way to calculate the opportunity cost. You are looking at the potential return of both choices with which you are faced. In making a decision regarding said choices, you would thus utilize this calculation to try and arrive at the smartest choice leading to the optimal return. You might also calculate opportunity cost after the fact. That is to say, once you've made your choice and start to see returns come in, you can then compare your return to what might have been had you gone in the other direction.
Of course, if you are calculating opportunity cost after the fact, the number is going to be much more accurate than if you were doing so based upon future predictions. Using real numbers rather than estimated projections is always going to result in a far more concise comparison of the two decisions in question. Calculating opportunity cost in hindsight can help you make adjustments moving forward and potentially make a better decision in the future.
For example, let's just say you are looking into buying stock in either company #1 or company #2. You opt for company #2. After a year, you go back and compare the two. Company #1 had a 10% return on investment whereas company #2 only had a 4% return. Your opportunity cost was therefore 6%.
The concept of opportunity cost applies to more than just financial investments. It can apply to a wide range of decisions in which foregoing one alternative for another could conceivably lead to a financial disparity of some sort. If someone for instance is deciding whether or not to do their landscaping versus hiring it out to a landscaping company, they would then weigh the money saved by doing it themselves against the time spent engaged in landscaping that could have otherwise been spent working and making money. You can easily calculate the opportunity cost in this scenario if you know how much time the project took you and how much you make hourly. So let's say you usually make 80.00 per hour. The landscaping took approximately 5 hours. That is 400.00 worth of timework you committed to your landscaping. If a landscaping company would've charged 300.00 for the same work, then your opportunity cost here would be 100.00.
There is a tradeoff with virtually any decision you make: watching TV versus cleaning the house, going back to school versus taking a semester off, doing work versus checking your social media accounts. Sometimes it may not necessarily come down to a monetary impact, but the tradeoff and subsequent opportunity cost are still there.
Some Limitations When It Comes to Opportunity Cost
The main limitation in factoring opportunity cost is that in trying to predict this cost you are relying on estimates. Certainly, studying past data and understanding how specific investments performed can help you make some predictions, but this is likely not going to be accurate. The accuracy only comes once you do make your choice between two things and then can go back after some time and determine exactly how each choice paid off.
And again, there are also those choices that are less quantifiable as they may not necessarily have to do with a specific financial return. The opportunity cost therefore associated with such choices would be less tangible and, in some instances, more philosophical.
In the end, what opportunity cost amounts to is the potential gain that is lost as a result of choosing option A over option B. To decide between the two, you need to look at any available information, make some estimations, and ultimately in some cases go with your intuition. You may not always be right and consequently may lose out, however, this is then data that you can use next time to help you make a better choice.
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