Opportunity Cost: Definition and Examples

What is the definition of opportunity cost

Economic profit does not indicate whether or not a business decision will make money. It signifies if it is prudent to undertake a specific decision against the opportunity of undertaking a different decision. As shown in the simplified example in the image, choosing to start a business would provide $10,000 in terms of accounting profits. However, the cost of the assets must be included in the cash outflow at the current market price.

What is the definition of opportunity cost

However, the painting took him four hours, effectively costing him $1,600 in lost wages. Let’s say professional painters would have charged Larry $1,000 for the work. The accounting profit would be to invest the $30 billion to receive $80 billion, hence leading to an accounting profit of $50 billion.

Accounting Profit vs. Economic Profit

As of October 2023, those 10,000 bitcoins would be worth about $343 million. If there is no opportunity cost in consuming a good, we can term it a free good. For example, if you breathe air, it doesn’t reduce the amount available to other people – there is no opportunity cost. See this interesting survey which shows people have very different responses when they understand the opportunity cost involved in a tax cut. If you have 12 hours at your disposal during the day, you could spend these hours in work or leisure.

  1. While opportunity costs can’t be predicted with absolute certainty, they provide a way for companies and individuals to think through their investment options and, ideally, arrive at better decisions.
  2. Economic profit, however, includes opportunity cost as an expense.
  3. There’s no way of knowing exactly how a different course of action will play out financially over time.
  4. Another important example of opportunity cost related to personal finance arises whenever you get a paycheck.
  5. Assuming an average annual return of 2.5%, their portfolio at the end of that time would be worth nearly $500,000.
  6. The opportunity cost here is the money you potentially could have earned if you’d invested it, whether in a mutual fund or a certificate of deposit.

In regard to this situation, the explicit costs are the wages and materials needed to fund soldiers and required equipment whilst an implicit cost would be the time that otherwise employed personnel will be engaged in war. In accounting, collecting, processing, and reporting information on activities and events that occur within an organization is referred to as the accounting cycle. Accounting is not only the gathering and calculation of data that impacts a choice, but it also delves deeply into the decision-making activities of businesses through the measurement and computation of such data. The two types of opportunity costs are explicit opportunity cost and implicit opportunity cost. For instance, if a restaurant buys $1,000 worth of ground beef, the cost is the other things that it could have purchased with that money, like chicken wings or hamburger buns. 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.

Grammar Terms You Used to Know, But Forgot

The existence of a fiduciary duty does not prevent the rise of potential conflicts of interest. For example, imagine your aunt had to decide between buying stock in Company ABC and Company XYZ. In this case, she can clearly measure her opportunity cost as 5% (8% – 3%). In this example, the firm will be indifferent to selling its product in either raw or processed form. However, if the distillation cost is less than $14.74 per barrel, the firm will profit from selling the processed product. And remember, regardless of your choice, you’ll incur some sort of opportunity cost.

What is the definition of opportunity cost

When it comes to your finances, opportunity cost works identically. Each choice you make has positive and negative repercussions and may cost you in different ways. Robert Johnson, a professor of finance at Creighton University, points to a classical example of the returns caution-minded investors miss out on when they downplay stocks in favor of more secure investments long term. When it comes to investment returns, you’ll just need to sub in the expected rates of return of each option. If, for instance, you’re deciding between an exchange-traded fund (ETF) with an expected return of 10% and a rental property that will provide a return of 8%, your opportunity cost of choosing the rental property over the ETF is 2%. Analyzing from the composition of costs, sunk costs can be either fixed costs or variable costs.

Other Costs in Decision-Making: Incremental Costs

Even making no decision is itself a decision with costs, especially when you consider the sleeper costs of inflation. Carefully constructed portfolios provide guidelines for the percentage of each type of asset you should hold to help mitigate the uncertainty of any one asset or asset class doing very well or very poorly over time. “This reduces the investor’s decisions from looking at every opportunity to a manageable question of ‘How much of each asset class should I hold? “A prime example is the opportunity cost of holding cash,” Johnson says. People like to think cash is king, he says, but holding exclusively dollar bills long term all but ensures you’ll experience large opportunity losses. In theory marginal costs represent the increase in total costs (which include both constant and variable costs) as output increases by 1 unit.

Application of Opportunity Cost

Now you’ll miss out on time with your family, also an opportunity cost. The biggest opportunity cost regarding liquidity has to do with the chance that you could miss out on a prime investment opportunity in the future because you can’t get your hands on your money that’s tied up in another investment. That’s a real opportunity cost, but it’s hard to quantify with a dollar figure, so it doesn’t fit cleanly into the opportunity cost equation.

No matter which option the business chooses, the potential profit that it gives up by not investing in the other option is the opportunity cost. Opportunity cost represents the potential benefits that a business, an investor, or an individual consumer misses out on when choosing one alternative over another. While opportunity costs can’t be predicted with total certainty, taking them into consideration can lead to better decision making. You can also consider the opportunity costs when deciding how to spend your time. He decides to close his office one afternoon to paint the office himself, thinking that he’s saving money on the costs of hiring professional painters.

For instance, assume that the firm described above has invested $30 billion to start its operations. However, a fall in demand for oil products has led to a foreseeable revenue of $50 billion. As such, the profit from this project will lead to a net value of $20 billion. A sunk cost is a cost that has occurred and cannot be changed by present or future decisions. As such, it is important that this cost is ignored in the decision-making process. A firm may choose to sell a product in its current state or process it further in hopes of generating additional revenue.