What is Opportunity Cost?

The opportunity cost is a theoretical concept that measures the cost of what is left to do when it is necessary to make a choice of any kind.

This cost differs from an actual cost, also known as an accounting cost, which occurs directly and quantitatively. The opportunity cost is based on a “qualitative cost” of what could be done.

The concept of opportunity cost in the economy

In the economy, the opportunity cost is explained by the conflict of choice that an economic agent has in a scenario of scarcity, that is, when one cannot have, at the same time, the objects of choice.

This concept explains that all agents in the economy make choices that enable the best benefit, in exchange for a lower cost.

Thus, the opportunity cost is also known as economic cost, as it is an opportunity that is no longer used.

The conflict of choice is known as a trade-off, which translates into a situation of choice when one thing is won and another is lost, and what is lost is the opportunity cost.

Examples of opportunity costs

Opportunity costs can be exemplified for any situation where there is a trade-off :

  • If a company makes a renovation, it stops buying new equipment or machinery for its production line;
  • When we buy a new TV, we stop buying a musical instrument;
  • For the government, the opportunity cost of expanding the defense program is also the amount that no longer invests in hospitals;
  • The opportunity cost of work can be considered as the benefit of having free time;
  • In an investment, the opportunity cost is measured by the value that other investments that could be made with the same amount return.

How to calculate opportunity cost

The opportunity cost, when it is possible to measure, is calculated based on the benefit that one would have with the option that was not chosen.

This calculation takes into account the benefit of the best alternative that had to be abandoned, either for an activity, but also, when purchasing a good, which becomes a cost for the one that was actually chosen.

Example of how to calculate opportunity cost

If a company buys steel sheets for US $ 100 thousand to produce automobiles, but has the option of reselling this raw material for US $ 130 thousand, the opportunity cost in producing is exactly the latter value.

The opportunity cost, or economic cost, takes into account an “implicit cost” which is precisely the benefit that one would have with what will be abandoned, in addition to the real cost.

It is possible to calculate in a more elaborate way by following a comparison between an activity A and another B, considering the benefit that is attributed to each one, as done below:

Opportunity cost of A: Benefit of B + [Actual cost A – Actual cost B]

Going back to the previous example, about the company that produces automobiles, we can consider production as activity A:

  • Benefit or revenue from car sales: US $ 200,000.00;
  • Production costs: US $ 120,000.00;
  • Other costs: US $ 30,000.00

And yet, activity B with the benefit of selling steel sheets for US $ 130,000.00 together at a cost of delivering them for US $ 10,000.00. The calculation of the opportunity cost of production is calculated:

Opportunity cost of A: 130,000 + [(120,000 + 30,000) – (130,000 + 10,000)] = 130,000 + 10,000 = US $ 140,000.00

And the opportunity cost of activity B:

Opportunity cost of B: 200,000 + [(130,000 + 10,000) – (120,000 + 30,000)] = 200,000 – 10,000 = US $ 190,000.00

For this reason, the opportunity cost is greater for the company to stop producing, that is, if it chooses to sell steel sheets.

Investment opportunity cost

In the financial field, the opportunity cost is also considered when the investor is able to choose different types of investments, with different returns.

To determine the opportunity cost, it is possible to consider the rate of return on the investment that has not been made, to calculate its updated value.

The higher the rate of return on the other investment, the lower the value of the investment in question.

Example

If investment A should return, at the end of its 2-year term, the value of US $ 10,000.00 and there is an investment B with a return rate of 4%, the updated value of A should be:

Current Value of A: 10,000 / (1 + 4%) ² = US $ 9,245.56

If the return on investment B is higher, the updated value of investment A will be even lower, since its opportunity cost is higher. See the example with the rate at 8%:

Current Value of A: 10,000 / (1 + 8%) ² = US $ 8,573.39