## What Is Opportunity Cost?

Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another. The idea of opportunity costs is a major concept in economics.

Because by definition they are unseen, opportunity costs can be easily overlooked if one is not careful. Understanding the potential missed opportunities foregone by choosing one investment over another allows for better decision-making.

While financial reports?do not show opportunity costs, business owners often use the concept to make educated decisions when they have multiple options before them. Bottlenecks, for instance, are often a result of opportunity costs.

### Key Takeaways

• Opportunity cost is the forgone benefit that would have been derived by an option not chosen.
• To properly evaluate opportunity costs, the costs and benefits of every option available must be considered and weighed against the others.
• Considering the value of opportunity costs can guide individuals and organizations to more profitable decision-making.
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## Opportunity Cost Formula and Calculation

?\begin{aligned} &\text{Opportunity Cost}=\text{FO}-\text{CO}\\ &\textbf{where:}\\ &\text{FO}=\text{Return on best foregone option}\\ &\text{CO}=\text{Return on chosen option} \end{aligned}?

The formula for calculating an opportunity cost is simply the difference between the expected returns of each option. Say that you have option A: to invest in the stock market hoping to generate capital gain returns. Option B, on the other hand is: to reinvest your money back into the business, expecting that newer equipment will increase production efficiency, leading to lower operational expenses and a higher profit margin.

Assume the expected return on investment in the stock market is 12 percent over the next year, and your company expects the equipment update to generate a 10 percent return over the same period. The opportunity cost of choosing the equipment over the stock market is (12% - 10%), which equals two percentage points. In other words, by investing in the business, you would forgo the opportunity to earn a higher return.

## Opportunity Cost and Capital Structure

Opportunity cost analysis also plays a crucial role in determining a business's capital structure.

A firm incurs an expense in issuing both debt and equity capital to compensate lenders and shareholders for the risk of investment, yet each also carries an opportunity cost. Funds used to make payments on loans, for example, cannot be invested in stocks or bonds, which offer the potential for investment income. The company must decide if the expansion made by the leveraging power of debt will generate greater profits than it could make through investments. A firm tries to weight the costs and benefits of issuing debt and stock, including both monetary and non-monetary considerations, in order to arrive at an optimal balance that minimizes opportunity costs. Because opportunity cost is a forward-looking consideration, the actual rate of return for both options is unknown today, making this evaluation in practice tricky.

Assume the company in the above example foregoes new equipment and instead invests in the stock market. If the selected securities decrease in value, the company could end up losing money rather than enjoying the expected 12 percent?return.

For the sake of simplicity, assume the investment yields a return of 0%, meaning the company gets out exactly what it put in. The opportunity cost of choosing this option is 10% - 0%, or 10%. It is equally possible that, had the company chosen new equipment, there would be no effect on production efficiency, and profits would remain stable. The opportunity cost of choosing this option is then 12%?rather than the expected 2%.

It is important to compare investment options that have a similar risk. Comparing a Treasury bill, which is virtually risk-free,?to investment in a highly volatile stock can cause a misleading calculation. Both options may have expected returns of 5%, but the U.S. Government backs the rate of return of the T-bill, while there is no such guarantee in the stock market. While the opportunity cost of either option is 0 percent, the T-bill is the safer bet when you consider?the relative risk of each investment.

## Comparing Investments

When assessing the potential profitability of various investments, businesses look for the option that is likely to yield the greatest return. Often, they can determine this by looking at the expected rate of return for an investment vehicle. However, businesses must also consider the opportunity cost of each option.

Assume that, given a set amount of money for investment, a business must choose between investing funds in securities or using it to purchase new equipment. No matter which option the business chooses, the potential profit it?gives up by not investing in the other option is the opportunity cost. Indeed, it is unavoidable.