Opportunity cost
The definition of opportunity cost is the potential gain lost by the choice to take a different course of action when considering multiple investments or avenues of business. When weighing two or more courses of action, the opportunity cost refers to the value of the option you necessarily sacrifice in order to pursue the option you decide upon. Regardless of which option is chosen, there will be a cost assigned to the option that is forgone—that is the opportunity cost.
Opportunity cost formula
Opportunity Cost = Benefit of Chosen Investment – Benefit of Forgone Investment
In any business, strategic action and investment are key to profitability. Considering the costs associated even with wise decisions is important to decisions going forward. While this opportunity cost definition chiefly references business strategy, it may also be applied advantageously to personal finance decisions.
Trade-off examples
Having examples can help to achieve a clearer understanding of the concept of opportunity costs. Three trade-off scenarios are discussed below.
- A business has $100,000 to invest in a financial product, such as stocks, bonds, or other securities. The business must choose between Product A, which has a return of 3%, and Product B, which has a return of 4%. The difference between them – 1% – represents the opportunity cost in this scenario.
- A business has $20,000 to spend on a new piece of industrial equipment. One option would increase the company’s output by an estimated 2%, while the other would increase output by an estimated 4%. The 2% difference is the opportunity cost in this example.
- A business can manufacture 5,000 units of Product A per business day, or 2,500 units of Product B during the same time period. For every unit of Product B the company manufactures, the same company could manufacture two units of Product A.
