Reviewed by Sep 30, 2020| Updated on
Opportunity cost denotes the benefits missed by an individual, investor, or business while choosing one alternative over another. While financial reports do not present opportunity cost, business owners can manage to make informed decisions when they have multiple options before them. Opportunity costs lead to bottlenecks.
Opportunity costs are unseen by definition and hence tend to be easily overlooked if one is not careful. Knowing the potential missed opportunities by picking one investment over another provides better decision-making ability.
Opportunity Cost = FO - CO where, FO refers to return on best-foregone option CO refers to return on the chosen option
The formula for computing an opportunity cost is just the difference between the expected returns of each option.
Suppose, Mr X has an option A to invest in the stock market, expecting to generate capital gain returns. Option B helps reinvest his money back into the business, assuming that new equipment will improve production efficiency, lowers the operational expenses, and allows a higher profit margin.
Consider that the expected return on investment in the stock market is 11% over the next year, and your business expects the equipment update to generate a 9% return over the same period. The opportunity cost of foregoing the stock market investment over a piece of equipment is (11%-9%), which is equal to 2 percentage points. Therefore, by investing in the business, one would forgo the opportunity to receive a higher return.
Analysis of opportunity cost plays an important role in planning a business's capital structure. Both debt and equity require the cost to compensate lenders and shareholders for the risk of investment, each of which also carries an opportunity cost.
Funds utilised for repayment of loans, for instance, are not invested in stocks or bonds that offer the potential for investment income. The company must determine if the growth made by the leveraging power of debt will generate greater profits than it could through investments.
The actual rate of return for both options is not known since the opportunity cost is a forward-looking calculation. Consider the company in the above example foregoes new equipment and invests in the stock market instead. If the chosen securities decrease in value, the company may end up losing money rather than enjoying the expected 11% return.