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Opportunity cost is a term that refers to the potential reward that you forgo when choosing one option over the next-best alternative. It’s a microeconomic concept that can be applied to many different situations, from a business determining what projects to pursue, to an employee deciding to work overtime or spend that time with their family, or an investor choosing an index fund over a self-managed portfolio.
Opportunity costs can be easily overlooked because sometimes the benefits are unrealized, and therefore, hidden from view.
When looking at opportunity costs, economists consider two types: explicit and implicit.
“Explicit costs are those that are incurred when taking a specific course of action,” says Dr. Bob Castaneda, program director of Walden University’s College of Management of Technology.
The explicit opportunity costs associated with a decision could include wages, materials, stock purchases, rent, utilities, and other tangible expenses. Any dollar amount required to move forward with a choice will fall under the explicit costs.
On the other hand, “implicit costs may or may not have been incurred by forgoing a specific action,” says Castaneda.
Implicit costs are indirect and can be difficult to identify. They represent the income or other benefits that could possibly have been generated had you made the alternative choice.
The formula to calculate opportunity cost is straightforward.
Here’s how it works:
Here’s a very simple way to put this formula into practice.
Let’s say you are deciding to invest in either Company A or Company B. You choose to invest in company A, which provides a return of 6% in one year. On the other hand, Company Z had a return of 10% in the same year.
The opportunity cost of choosing to invest in Company A versus Company B is 10% minus 6%. With that choice, the opportunity cost is 4%, meaning you would forgo the opportunity to earn an additional 4% on your funds.
Opportunity costs matter to investors because they are constantly selecting the best option among investments.
“Whenever an investor buys assets, they implicitly choose not to buy others,” says Brian Jenkins, an associate professor of economics at the University of Calfornia, Irvine. Jenkins, expands with an example:
“From 2002 to 2021 the S&P 500 produced an average annual return of about 11%. Suppose that over that time, an investor managing her own portfolio was able to produce an annual return of 8%. By choosing to manage her own portfolio instead of holding a low-cost index fund that tracks the S&P 500, the investor gave up about 3% per year for 20 years (and probably took on more risk too), a substantial implicit opportunity cost.”
As an investor, weighing out the opportunity cost of each investment decision you make can help you make the most prudent decisions. Without this careful weighing of the options, you may find your portfolio filled with easily outperformed assets.
Every decision has trade-offs involved, not just investing. So, how does opportunity cost play out in the real world? Here are some examples to consider:
Now, take a minute to consider the decisions on the horizon in your life. Understanding the opportunity costs associated with your choices could illuminate the best path forward.
Another concept in cost accounting is sunk costs.
“Sunk cost refers to the past costs that you have incurred,” says Ahren A Tiller, Esq., Bankruptcy Law Specialist. “Let’s say you’ve invested in company X but gained nothing. The money you spent is a sunk cost, and it can’t be recovered. You can’t do anything about it, making it irrelevant in your decision-making.”
In contrast, opportunity cost considers the loss of potential returns from an alternative investment decision.
For example, the money you’ve already spent on rent for your office space is a sunk cost. But the funds you haven’t spent on office furniture yet would be considered an opportunity cost because you haven’t actually spent the money yet.
Ultimately, Tiller says, “considering the opportunity cost will help show the most profitable option to invest in, making the decision-making process easier for you.”