Learn About Opportunity Cost and its Need: Opportunity cost is the price of missed opportunity that comes the alternative choice of the best degree. It is like choosing one opportunity over other by an investor, individual or a business.
Business owners can make use of it in making sensible decisions out of myriad options. As per the oxford dictionary, it is a disadvantage caused by choosing another alternative over a plethora of others. It is the loss of benefit in simple terms, arising from missing-out other opportunities.
Not Counting The Opportunity Cost
Quite often, people remain unseen to these lost opportunities and their prices, and upon realising, it is essential to understand the significance of letting them go due to a favourable chance, which is a part of proper decision making.
Here’s the formula for calculating the opportunity cost
Opportunity Cost=FO(Return on forgone option) −CO (Return on chosen option)
For calculating it, a business owner or an individual trader can calculate the total FO and then subtract it from the options chosen, which is CO. The remaining amount would be the opportunity cost lost.
Suppose, there is an anticipation that a forex market currency would rise more than 15 per cent if a trader chooses to make an investment. But at the same time his/her company requires some crucial equipment that would hike the potential of working and profits around 12 per cent. The fund remains limited here.
Hence, if the owner picks the latter option the benefits let go off would be calculated as:- 15%-12%= 3% In short, prioritising business over the investments in commodities incurred a cost of three per cent.
The Potential Profitability
While making a decision, most businesses look for a long-term output that might have short-term repercussions but may yield higher returns in days to come. The determination of the prospect happens by looking at the rate of return on a given project for investment. Although it is advisable for businesses to consider the cost of benefits, the foregone opportunities could provide.
One can also calculate on the mood or having a luxury for not working or devoting hours in work for making an extra income. The wages for those, suppose 12-15 hours are also among opportunity cost. If someone is getting paid as much as $ 30 per hour, then not working for 15 hours a week would cost him/her around $ 450.
Priorities of the Government’s Expenditure
Sometimes, governments have to preferences some activities or sectors over the other. The recent example remains the Covid-19 aka coronavirus crisis that has got the world under its firm grip. Several governments in the world are diverting their funds allocated to other segments and area toward health & care, enhancing medical facilities and researching for the anti-virus.
If a sum of Euro 15 billion is spent over the health, then that would mean, there would be a deduction of expenditure in the fields like education, infrastructure, army, transport and many more.
Letting Go of Luxuries Today
An investment for security the future on the expense of letting go of today’s needs or luxuries also count for the opportunity cost. It is like giving up on consumer goods for investing in capital gains schemes.
Use of Farmland
If farmers start using their lands for producing bio-fuel that would mean there is a scarcity of edible products like wheat, barley, rice, pulses and other crops.
Investment in Financial Markets
Spending in financial markets can explain the opportunity cost in the most ordinary way. Suppose if an investor has savings to invest and wants to use it for investing in commodities, stocks, forex, indices or crypto. But he/she can only invest in one asset at a time and chooses stocks, while the commodity market does better than the anticipation, then there occurs the opportunity cost.
Comparison with Risk Factors
The risk is the projected benefits while venturing into an investment or starting a business from the start by an individual and a potential threat of losing the principal sum amount while driving it. On another level, here it is the returns on the chosen investment are fewer than the one forgone.
Difference Between Risk and Opportunity Cost
In risk, the comparison takes place between the projected performance and the actual performance of investments by an individual or a business. Whereas, in the opportunity cost, there is collation between the actual performance and one investment with the other on a scale of a certain parameter.
Comparison Between Sunk Cost and Opportunity Cost
The opportunity cost does not necessarily include cash outflows, and it is the calculation of the chance lost to make a profit through other options. Whereas sunk cost is the costs which have already incurred and should not display in the incremental cash flows, which is used in estimating the internal rate of return and the net present value.
So, it can be summarised in potential profits not earned against the money already spent because the funds were invested elsewhere.
Opportunity cost is best explained by what if. In business and financial markets precisely, most people making an investment are from the middle-class. They have limited funds. So, they can either spend that on the luxuries of life or congregating it for the future. And like life, a person has to take one alternative with a leap of faith and assume that as a better decision. The chances of it being the best are always 50 per cent.