opportunity cost

In economics, opportunity cost definition gives the benefits or value lost by business owners, small businesses, organisations, investors, or individuals because they choose to accomplish or achieve something else. It assists organisations in making better decisions by displaying the missed opportunity as a result of investing in something other than shares, the stock market, real estate, land, services, and so on. In general, the financial report does not include the opportunity cost because it is not only about money. It is also associated with the lost time spent doing something else that is useful. In simple terms, it is a microeconomic concept that informs you about the output and potential opportunities that have been foregone.

How to calculate opportunity cost?

The opportunity cost is the additional return on the given alternative available addition with an option to choose from.  

For instance, here’s an opportunity cost example. Some people spend less time going to the cinema to study for a test to get a good grade. The opportunity cost is the value of a movie as well as the enjoyment gained from watching it. You will have to choose between rocky road and strawberry ice cream at the ice cream parlour. the difference between the return from the most lucrative alternative and the receiving return from the previously chosen option.

This opportunity cost example calculation has a broad scope of applications. The concept of opportunity cost is most commonly used in the planning of product decisions, but it is also suitable in almost several other business occasions. The method is used to determine the prices paid for factor services and calculate economic rent, considering the actual difference between the actual return on factor services and their supply amount. 

Calculating the cost of opportunity is not limited to the producers. Consumers also use the cost opportunity procedure to find the different consumption bundles between each other. 

Different Kinds of Opportunity Costs:

There are two kinds of opportunity costs. There are two types of costs: explicit costs and implicit costs.

As narrated, Explicit costs are self-explainable, which means the real costs can be clearly identified—the same explicit costs that are incurred and documented in the accounting books. These outright expenses had to be paid directly or in kind. For instance, if a piece of machinery in the company breaks down, the cost of repairing it is clearly stated. The repair work and reinstalling work must be paid in cash, and the payment is recorded as an expenditure in the account books.

Implicit costs are those that are indirect or invisible and cannot be tracked directly or easily. One of the firm’s implicit costs is the loss of owned resources. Because there is no real or actual cost, payments are rarely made. For example, if a piece of machine in a company breaks down, there is an implicit cost of production loss in addition to the cost of repairing it. Because the machinery in that unit is broken, production is halted, and there are many other resources that are valuable, known as human resources, that are being squandered. 

Explain Increasing Opportunity 

The idea of increasing opportunity cost formula is most commonly witnessed in the production possibility frontier, which depicts the possibility of producing various joined bundles of two goods with an ample amount of resources. The slope of the Production Possibility Frontier is a curve to the origin and represents the opportunity cost. Because the PPF is concave to the origin, it demonstrates how it allows more time of producing more than one good increase over time. The rising nature of economic cost is usually described in terms of resource inefficiency when used to generate several types of goods.

What does opportunity cost reflect? 

Opportunity cost formula analysis is critical in determining a company’s capital structure. A company incurs costs when it issues debt or equity to recompense lending institutions and stockholders for the investment, but each incurs an opportunity cost.

Loan repayments, for instance, cannot be decided to invest in stocks or bonds, which could generate investment income. The company must decide whether the expansion made possible by leveraging debt will result in higher profits than it could have made through investments.

A company attempts to balance the benefits and costs of issuing debt and stock, taking into account both monetary and non-monetary considerations, in order to achieve an ideal balance that minimises opportunity costs. Because opportunity cost is a prospective factor to consider, the real rate of return for both choices is unidentified today, trying to make this evaluation difficult in practice.

Presume the business in the preceding example foregoes new equipment in favour of stock market investment. If the value of the chosen securities falls, the company may lose money rather than earning the expected 12 per cent return.

Just for simplification, presume the money invested yields a 0% return, implying that the company receives exactly what it puts in. The potential cost of selecting this option ranges from 10% to 0% or 10%. It is also possible that if the company had selected new equipment, there would have been no impact on production efficiency, and profits would have remained stable. The opportunity cost of selecting this alternative is then 12% instead of the expected 2%.

It is critical to make comparisons between investment options with comparable risks. When trying to compare a Treasury bill, which is nearly risk-free, to an investment in a highly volatile stock, a misleading calculation can be made. 

Conclusion: 

Opportunity cost definition is a fundamental economic principle that also applies to businesses. It is critical to learn and understand the concept in order to make better business decisions. The best way to accomplish this is to study and practice, which will give you a clear understanding of how it works. When making financial decisions, it is critical to consider opportunity cost – the amount of money you must spend in order to obtain something else. Opportunity cost is a fundamental economic principle that also applies to businesses. Essentially, it is what you give up when taking a different path.