Opportunity cost is the potential benefit that is missed or given up when choosing one alternative over another.

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Why is opportunity cost important?

Recognizing opportunity costs helps businesses make informed decisions by considering the potential benefits of alternative courses of action.

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An easy way to understand opportunity cost is:

Think of it as the road not taken. When you choose one path, you miss out on the potential benefits of the other path, just like choosing one opportunity means giving up another.

Formula, & Examples Of Opportunity Cost

Opportunity cost is the potential benefit that is foregone when choosing one alternative over another. It represents the cost of the next best alternative that is not chosen.

The formula for opportunity cost is:

Opportunity Cost = Return of Best Foregone Alternative - Return of Chosen Alternative

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For example, let's consider an investor who has $10,000 to invest and is considering two options:

Option A: Invest in a bond with a 5% annual return

Option B: Invest in a stock with a 10% annual return

The investor chooses Option A and invests in the bond. The opportunity cost of this decision would be:

Opportunity Cost = Return of Best Foregone Alternative (Option B) - Return of Chosen Alternative (Option A)

Opportunity Cost = (10% × $10,000) - (5% × $10,000)

Opportunity Cost = $1,000 - $500 = $500

In this example, the opportunity cost of choosing to invest in the bond is $500, which represents the additional return the investor could have earned by choosing the stock instead.

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Another example of opportunity cost is a student deciding between attending college and working full-time. If the student chooses to attend college, the opportunity cost would be the income they could have earned by working full-time during that period.

Let's say the student could have earned $30,000 per year working full-time, and the college tuition is $20,000 per year.

The opportunity cost of attending college for one year would be:

Opportunity Cost = Return of Best Foregone Alternative (Working Full-Time) - Return of Chosen Alternative (Attending College)

Opportunity Cost = $30,000 - (-$20,000) = $50,000

In this example, the opportunity cost of attending college for one year is $50,000, which represents the foregone income and the cost of tuition.

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Opportunity cost is considered in every strategic decision we make, ensuring that the resources committed to one option aren't better spent on another. This consideration helps us allocate resources effectively, maximizing the potential benefits of our business activities.