Opportunity Cost

Opportunity costs represent the benefits an individual, investor or business misses out on when choosing one alternative over another. While financial reports do not show opportunity cost, business owners can use it to make educated decisions when they have multiple options before them. Bottlenecks are often a cause of opportunity costs.

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.

Opportunity Cost Formula and Calculation

Opportunity Cost=FO−CO

where:

FO=Return on best foregone option

CO=Return on chosen option

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 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.