How To Calculate Opportunity Cost

How To Calculate Opportunity Cost

The opportunity cost is one of the very commonly used terms in finance or economics. It is the comparison between the returns on the best option which is not chosen and the return on the option which is chosen. The comparison of these two often arises in economics or finance when one is trying to evaluate different investment options. If you are here to know about how to calculate opportunity cost, then you are in the right place. Here we will discuss why calculating the opportunity cost is important and how to do it.

Why calculate the opportunity cost?

Any financial analyst or economist will determine or evaluate the opportunity cost before investing somewhere. This helps in quantifying the impact of actually choosing an investment over another one. The main reason why you must evaluate the opportunity cost is to consider the reality before selecting a particular investment option. Whenever you are in a dilemma with two options in front of you, the best way to determine is by calculating the opportunity cost. Comparing the two options and evaluating the difference in the returns of the two can give you the idea. With this, you will be able to get some benefits such as:

  • A better awareness of the lost opportunity
  • Comparison of the relative prices and determining the best

Though opportunity cost is mainly applied for investment purposes, it is also applied to many aspects of the life decisions where the money is the root cause of making any decision. Investors consider evaluating the potential opportunity cost while making any investment choices. But the actual result of the opportunity cost is more accurate when the investors have the real numbers to work with. But sometimes they calculate the opportunity cost based on estimations to find out the best option for them.

This is often used by the investors for comparing their investments or to compare where to invest further to maximize the return. The opportunity cost can be determined before the investment as well as after the investment. Before the investment, the estimated returns are considered based on previous years to evaluate the best option for investment. The opportunity cost that is calculated after the investment is done for evaluating the lost opportunity.

How to calculate opportunity cost?

Now, the main thing is to determine - how to calculate opportunity cost? It is actually quite simple. An investor can calculate the opportunity cost by comparing the returns made by both the options. You can estimate the future return of the option 1 and option 2, first. Then you have to find out the difference between the return of the option 1 and option 2. The result is actually the opportunity cost and this plays a huge role in comparing the returns and making the right decision.

Here is the formula that illustrates how to calculate the opportunity cost:

Opportunity cost = Return on the option 1 which is not chosen minus (-) Return on the option 2 which is chosen

So, based on this formula, we will present you with an example. Imagine you want to invest in Company A or Company B. Between these two, you decided to invest in Company B. After a year, Company B produces a return of 10% while Company A produced a return of 13%. So, the opportunity cost is the return of Company A i.e. 13% minus the return of Company B i.e. 10%. The end result is 3%. So, the opportunity cost is 3%.

Summary

So, it is quite clear why the opportunity cost is important and how to calculate opportunity cost. Before you invest in any stocks, properties, or anything, evaluating the opportunity cost can help you in many ways. Financial analyst or investment analysts are always calculating the opportunity cost of option A and option B to find out the best investment option for the companies or individuals.

Does evaluate opportunity cost can help after investment?

No. The opportunity cost is only for determining the potential loss that you have incurred due to the missed opportunity of not choosing the highest return option.

Does the opportunity cost affect the wants and needs?

Of course, the opportunity cost has an impact on the wants and needs as it analyzes the best choice for you, irrespective of your wants or needs.

Is the opportunity cost positive or negative?

It can be both! If you are at the losing end, then the opportunity cost is negative. If you are on the winning end, then the opportunity cost is positive.