In this article, I will discuss how to calculate opportunity cost, a significant concept sometimes introduced in economics.
By appreciating the consequences of the best alternative forgone, evaluating and choosing the options that maximize benefits is possible.
Let’s follow the steps and examples to help you grasp this crucial skill.
What Is Opportunity Cost?
Opportunity cost is a good term for describing the loss of net benefit caused by selecting one way of investing instead of another.
It is a basic economic principle of absolute scarcity that weighs the opportunity costs of each situation.
For example, when a firm spends its finances on buying state-of-the-art equipment instead of promoting its sales, the lost opportunity cost is the extra revenue that would have arisen from more sales.
Opportunity costs are useful to people because they make efficient decisions and yield the most returns for the cost incurred.
How To Calculate Opportunity Cost
Opportunity cost is the cost of benefits that indeterminate individuals may have lost due to choosing one alternative over others. Here’s a practical way to compute it:
Formula
Opportunity Cost Return from best opt option glazed over – Return from option chosen.
Steps to Calculate
Identify Alternatives: List all the alternatives available to you.
Estimate Returns: For each alternative, come up with the possible return.
Apply the Formula: Deduct the chosen alternative return value from the maximum benefit that would have been achieved through better decision-making.
Example
Suppose you have $1,000 with an aim of investing it; which of the following two options would you prefer:
Option A: To buy a stock that will likely earn 8%.
Option B: To invest in bonds that are likely to earn 5%.
If you go with Option B, what would the opportunity cost be?
Opportunity Cost= 8%−5%= 3%
This implies that you have suffered a loss of 3% because you took the bond rather than the stock.
Concept with Visualization – Opportunity Cost
Each of us has an opportunity to make a decision, whether it is about our daily activities, investments, or business conduct.
This sacrifice is not always in the form of money. It could be in time, resources, or any other opportunity that will be lost.
For example, suppose you choose to study for an upcoming exam instead of going to the movies and hanging out with friends. In that case, the opportunity cost is the pleasure of watching a movie and socializing with friends.
By understanding opportunity cost, individuals and companies can see and avoid the unfavorable effects they seem to miss or neglect when deciding.
Significance of Opportunity Cost
Increase efficiency in the resource allocation process
The practical unit allocation of resources is critical since it allows individuals and businesses to focus their scarce resources, such as time, cash, and workforce, on the best opportunities available.
Opting to calculate opportunity cost allows planners and managers to focus more on investments or projects that will return the best and use their resources effectively, thus enhancing productivity and impact.
Rational Decision Making
Opportunity cost is helpful in rational decision-making as it compels individuals to evaluate the “cost” and benefits of every option chosen.
Consequently, by analyzing different actions objectively and logically related to the goals to be achieved, decision-makers are likely to reduce the chances of making regrettable decisions or earning less than what was needed.
Maximizes Returns and Benefits
Considering opportunity cost, they and any organization would concentrate on the areas that yield the most benefits.
They can maximize such strong points to do even better, pursuing possibilities with the most significant possible rewards.
Ways in which opportunity cost can be reduced
Broadening the spread of Investments
Spreading growth-oriented or investment-seeking mechanisms, referred to as diversification, can curtail the potentiality of opportunities for growth or exploitation.
There is no reason any investment should have all the funds aimed at it, which would make an investor miss out on better investment options. Diversifying enables an investor to reap benefits from various areas.
Organize and Allocated Time
Time is a limited resource. Opportunities that take longer to finish can be completed in a shorter period if proper time management techniques are employed.
In individual pursuits and business activities, self-organization and division of labor, time, and efforts ensure that priority is given to the most urgent and essential works.
Look For Alternatives
Typically, the decision-making process implies that one makes a particular choice among different alternatives—and in most cases, the first one evaluates only the pros and leaves out the cons.
When forced to compare potential gains from the outcomes, avoidance, and opportunities, this evaluation does not only look at the risk factors but also what may be lost by venturing into a particular strategy.
This is how it is justified that risks are minimal if the given decision is made with the knowledge of all the options and proper reasoning.
Conclusion
It is essential to assess opportunity cost as it will enable one to enhance decision-making for better outcomes.
It is apparent that when one examines the alternatives, figures out the possible returns, and uses the simple formula, the attainable option in any option is easy to see and comprehensively evaluate.
This view lets you use scarce resources judiciously so that the optimum achievement is not overlooked.
A clear understanding of the principles of opportunity cost helps any person, whether it be an investor, a company owner,
Regular people make choices daily to make better, more intelligent decisions that allow them to achieve more success and happiness.
