However, if the distillation cost is less than $14.74 per barrel, the firm will profit from selling the processed product. A land surveyor determines that the land can be sold at a price of $40 billion. 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 and hundreds of finance templates and cheat sheets.

Knowing how to calculate opportunity cost can help you accurately weigh the risks and rewards of each option and factor in the potential long-term costs of doing so. For example, a stock with a potential 10 percent annual return has more risk than investing in a CD with a sure-fire 5 percent annual return. So the opportunity cost of taking the stock is the CD’s safe return, while the cost of the CD is the stock’s potentially higher return and greater risk. The stock’s risk and potential for loss may make the lower-yielding investment a more attractive prospect. If you don’t have the actual rate of return, you can weigh the investment’s expected return.

They represent the income or other benefits that could possibly have been generated had you made the alternative choice. Accounting profit is the net income calculation often stipulated by the generally accepted accounting principles (GAAP) used by most companies in the U.S. Under those rules, only explicit, real costs are subtracted from total revenue. One of the most dramatic examples of opportunity cost is a 2010 exchange of 10,000 bitcoins for two large pizzas, which at the time was worth about $41. As of October 2023, those 10,000 bitcoins would be worth about $343 million.

In financial analysis, the opportunity cost is factored into the present when calculating the Net Present Value formula. To go deeper into opportunity cost calculation, use the advanced mode, and follow the formulas below. Keep reading to find more about the assumptions this tool uses, how to record accounts payable transactions, and the opportunity cost definition. You may also find it useful to go through an opportunity cost example, which provides you with a step-by-step model you can adjust to your own needs. Alternatively, if the business purchases a new machine, it will be able to increase its production. 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.

Opportunity cost attempts to assign a specific figure to that trade-off. In the investing world, investors often use a hurdle rate to think about the opportunity cost of any given investment choice. If a potential investment doesn’t meet their hurdle rate, then investors won’t make the investment. So the hurdle rate acts as a gauge of their opportunity cost for making an investment. While the definition of opportunity cost remains the same in investing, the concept is a bit more nuanced because of potential differences among investments. The opportunity cost of investing in one stock over another can differ because investments have varying risks and rewards.

This means that the only way to get more of one good is to give up some of the other. Where P and Q are the price and respective quantity of any number, n, of items purchased and Budget is the amount of income one has to spend.

He decides to close his office one afternoon to paint the office himself, thinking that he’s saving money on the costs of hiring professional painters. However, the painting took him four hours, effectively costing him $1,600 in lost wages. Let’s say professional painters would have charged Larry $1,000 for the work. An investor calculates the opportunity cost by comparing the returns of two options.

Why opportunity cost matters for investors

Any effort to predict opportunity cost must rely heavily on estimates and assumptions. There’s no way of knowing exactly how a different course of action will play out financially over time. Investors might use the historic returns on various types of investments in an attempt to forecast their likely returns. However, as the famous disclaimer goes, “Past performance is no guarantee of future results.”

While we strive to provide a wide range of offers, Bankrate does not include information about every financial or credit product or service. Here’s how opportunity cost works in investing, plus the differences between opportunity cost, risk and sunk costs. If you are wondering how to calculate opportunity cost, check the sections below to find its formula and some more examples. 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.

How to calculate opportunity cost

That’s a real opportunity cost, but it’s hard to quantify with a dollar figure, so it doesn’t fit cleanly into the opportunity cost equation. You chose to read this article instead of reading another article, checking your Facebook page, or watching television. Your life is the result of your past decisions, and that, essentially, is the definition of opportunity cost. For example, imagine your aunt had to decide between buying stock in Company ABC and Company XYZ.

1. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.
2. Opportunity costs matter to investors because they are constantly selecting the best option among investments.
3. “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 opportunity cost attempts to quantify the impact of choosing one investment over another. Sunk costs should be irrelevant for future decision making, while opportunity costs are crucial because they reflect missed opportunities. That’s not to say that your past decisions have no effect on your future decisions, of course.

For example, when a company evaluates new investments, it considers both the expected return on investment and the opportunity cost, including alternative investments, the cost of debt or any alternative use of the cash. Opportunity cost is often used by investors to compare investments, but the concept can be applied to many different scenarios. 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. To answer the question “What is the opportunity cost?”, imagine you are deciding between buying two things that you plan to eventually sell. The difference between the future profits is the opportunity cost definition.

What is opportunity cost?

If you plug other numbers of bus tickets into the equation, you get the results shown in Table 1, below, which are the points on Charlie’s budget constraint. Buying 1,000 shares of company A at $10 a share, for instance, represents a sunk cost of $10,000. This https://www.quick-bookkeeping.net/dollar-value-lifo-method-calculation/ is the amount of money paid out to invest, and it can’t be recouped without selling the stock (and perhaps not in full even then). Money that a company uses to make payments on its bonds or other debt, for example, cannot be invested for other purposes.

Now we have an equation that helps us calculate the number of burgers Charlie can buy depending on how many bus tickets he wants to purchase in a given week. The decision in this situation would be to continue production as the $50 billion in expected revenue is still greater than the $40 billion received from selling the land. The $30 billion initial investment has already been made and will not be altered in either choice. For instance, assume that the firm described above has invested $30 billion to start its operations. However, a fall in demand for oil products has led to a foreseeable revenue of $50 billion. As such, the profit from this project will lead to a net value of $20 billion.

If we want to answer the question, “how many burgers and bus tickets can Charlie buy? 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 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. For example, the money you’ve already spent on rent for your office space is a sunk cost.