For example, imagine your aunt had to decide between buying stock in Company ABC and Company XYZ. In this case, she can clearly measure her opportunity cost as 5% (8% – 3%). The accounting profit would be to invest the $30 billion to receive $80 billion, hence leading to an accounting profit of $50 billion. However, the economic profit for choosing to extract will be $10 billion because the opportunity cost of not selling the land will be $40 billion.
How to calculate opportunity cost
Opportunity cost is the cost of what is given up when choosing one thing over another. In investing, the concept helps show the cost of an investment choice by showing the trade-offs for making that choice. Opportunity cost can be applied to any situation where you need to make a choice between two or more alternatives. Here is the way to calculate opportunity cost, along with some ways it can be used to inform your investment decisions and more. A sunk cost is a cost that has occurred and cannot be changed by present or future decisions.
- While opportunity costs can’t be predicted with absolute certainty, they provide a way for companies and individuals to think through their investment options and, ideally, arrive at better decisions.
- In other words, any time someone buys an item in the present, he is giving something up in the future.
- So, if you chose to invest in government bonds over high-risk stocks, there’s a trade-off in the decision that you chose.
- Assume that a business has $20,000 in available funds and must choose between investing the money in securities, which it expects to return 10% a year, or using it to purchase new machinery.
- Under those rules, only explicit, real costs are subtracted from total revenue.
How to Calculate Opportunity Cost
A consultant determines that extracting the oil will generate an operating revenue of $80 billion in present value terms if the firm is willing to invest $30 billion today. Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses https://www.kelleysbookkeeping.com/ and hundreds of finance templates and cheat sheets. Consumers can harness opportunity cost to evaluate different choices and the value they will forgo by selecting those choices. One of the most dramatic examples of opportunity cost is a 2010 exchange of 10,000 bitcoins for two large pizzas—at the time worth about $41.
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Other factors, such as our own proprietary website rules and whether a product is offered in your area or at your self-selected credit score range, can also impact how and where products appear on this site. While we strive to provide a wide range of offers, Bankrate does not include information about every financial or credit product or service. A sunk cost is money already spent at some point in the past, while opportunity cost is the potential returns not earned in the future on an investment because the money was invested elsewhere.
Why opportunity cost matters for investors
If your friend chooses to quit work for a whole year to go back to school, for example, the opportunity cost of this decision is the year’s worth of lost wages. Your friend will compare the opportunity cost of lost wages with the benefits of receiving a higher education degree. Investors are always faced with options about how to invest their money to receive the highest or safest return. The investor’s opportunity cost represents the cost of a foregone alternative. If you choose one alternative over another, then the cost of choosing that alternative becomes your opportunity cost.
For example, if an investor decides to put $100 into ABC stock, that is $100 he cannot put into XYZ stock, or alternatively, some other kind of asset, for example a bond. Alternatively, if an individual spends $20,000 on https://www.kelleysbookkeeping.com/contingent-liability-definition/ a sedan, he cannot put that same amount toward a minivan. This theoretical calculation can then be used to compare the actual profit of the company to what its profit might have been had it made different decisions.
When considering two different securities, it is also important to take risk into account. For example, comparing a Treasury bill to a highly volatile stock can be misleading, even if both have the same expected is an invoice the same as a bill with definitions and examples return so that the opportunity cost of either option is 0%. That’s because the U.S. government backs the return on the T-bill, making it virtually risk-free, and there is no such guarantee in the stock market.