How to Calculate Opportunity Cost: 10 Steps with Pictures

how to compute 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. Brent Davis has been writing about the financial markets for 10 years and worked https://www.kelleysbookkeeping.com/book-balance-definition/ in research for the last five years at a Fortune 500 company. Brent’s investing strategy is to buy high-quality companies and then let compounding do its thing. Another way to minimize the risk of monetary loss is to diversify your investments.

how to compute opportunity cost

Example of an Opportunity Cost Analysis for a Business

Over time you might find that your initial calculation was inaccurate, especially when working with something volatile like the stock market. However, it’s important to note that opportunity cost can aid in deciding between two risk profiles. For example, let’s say you have the option between investment #1, which is rather precarious, but has a possible ROI of 21%, or investment #2, which is considerably less risky, but only has an ROI of 7%. For instance, the trade-off cost of choosing to invest in a yacht over a sailboat can be estimated through how choosing one over the other will affect your savings account.

how to compute opportunity cost

About This Article

While we strive to provide a wide range of offers, Bankrate does not include information about every financial or credit product or service. Here’s how opportunity cost works in investing, plus the differences between opportunity cost, risk and sunk costs. While opportunity costs can’t be predicted with absolute certainty, they provide a way what do i need to open a business bank account for companies and individuals to think through their investment options and, ideally, arrive at better decisions. 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.

When and Where Opportunity Cost Calculations Are Useful

  1. Where P and Q are the price and respective quantity of any number, n, of items purchased and Budget is the amount of income one has to spend.
  2. Especially if you have a specific financial goal in mind, it’s important to make plans to help you achieve that goal.
  3. Get global corporate cards, ACH and wires, and bill pay in one account that scales with you from launch to IPO.
  4. It focuses solely on one option and ignores the potential gains from other options that could have been selected.

Any effort to predict opportunity cost must rely heavily on estimates and assumptions. There’s no way of knowing exactly how a different course of action will play out financially over time. 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.” For financial investment decisions, one of these values might be time.

This is the amount of money paid out to invest, and it can’t be recouped without selling the stock (and perhaps not in full even then). Money that a company uses to make payments on its bonds or other debt, for example, cannot be invested for other purposes. So the company must decide if an expansion or other growth opportunity made possible by borrowing would generate greater profits than it could make through outside investments.

Our writers and editors used an in-house natural language generation platform to assist with portions of this article, allowing them to focus on adding information that is uniquely helpful. The article was reviewed, fact-checked and edited by our editorial staff prior to publication. “Expert verified” means that our Financial Review Board https://www.kelleysbookkeeping.com/ thoroughly evaluated the article for accuracy and clarity. The Review Board comprises a panel of financial experts whose objective is to ensure that our content is always objective and balanced. Use this process to make logical comparisons between complex options. In this example, time is just one factor in the decision you are making.

Knowing how to calculate opportunity cost can help you better approach your capital structure. The purely financial opportunity cost of choosing the CD over the CMA is $322.59 in earnings. Although you’d earn more with a CD, you’d be locked out of your $11,000 and any earnings in the event of an emergency or financial downturn. Suppose, for example, that you’ve just received an unexpected $1,000 bonus at work.

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