What is Opportunity Cost?
Opportunity cost is the profit lost when one alternative is selected over another. The concept is useful simply as a reminder to examine all reasonable alternatives before making a decision.For example, you have $1,000,000 and choose to invest it in a product line that will generate a return of 5%. If you could have spent the money on a different investment that would have generated a return of 7%, then the 2% difference between the two alternatives is the foregone opportunity cost of this decision.
Opportunity cost does not necessarily involve money. It can also refer to alternative uses of time. For example, do you spend 20 hours learning a new skill, or 20 hours reading a book?
Examples of Opportunity Cost
The term is commonly applied to the decision to expend funds now, rather than investing the funds until a later date. Examples are:
- Go on vacation now, or save the money and invest it in a house.
- Go to college now, in hopes of generating a large return from the college degree several years in the future.
- Pay down debt now, or use the money to buy new assets that could be used to generate additional profits.
It is easy to incorrectly include or exclude costs in an opportunity cost analysis. For example, the opportunity cost of attending college does not include room and board, since you would still make this expenditure even if you were not attending college.
Estimation of Opportunity Cost
Opportunity cost cannot always be fully quantified at the time when a decision is made. Instead, the person making the decision can only roughly estimate the outcomes of various alternatives, which means imperfect knowledge can lead to an opportunity cost that will only become obvious in retrospect. This is a particular concern when there is a high variability of return. To return to the first example, the foregone investment at 7% might have a high variability of return, and so might not generate the full 7% return over the life of the investment.
Opportunity Cost vs. Sunk Cost
There are significant differences between opportunity costs and sunk costs. A sunk cost is a cost that has already been paid for, whereas an opportunity cost is a prospective return that has not yet been earned. Thus, a sunk cost is backward looking, while an opportunity cost is forward looking. For example, a business pays $50,000 to acquire a piece of custom machinery; this is a sunk cost. Conversely, the opportunity cost represents an analysis of how the $50,000 might otherwise have been used.
When Not to Use Opportunity Cost
The concept of opportunity cost does not always work, since it can be too difficult to make a quantitative comparison of two alternatives. It works best when there is a common unit of measure, such as money spent or time used.
Opportunity cost is not an accounting concept, and so does not appear in the financial recordsof an entity. It is strictly a financial analysis concept.