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Oh, Oppurituntiy Cost how I love thee, Let me count the ways”…
Counting the ways, is actually what can make calculating opportunity costs difficult. It may not be as simple as A vs B. You may need to take into account C and D.
So how do you do this?
REad below to find out…
How is Opportunity Cost Calculated?
In financial analysis, the opportunity cost is factored into the present when calculating the Net Present Value formulaNPV FormulaA guide to the NPV formula in Excel when performing financial analysis. It’s important to understand exactly how the NPV formula works in Excel and the math behind it. NPV = F / [ (1 + r)^n ] where, PV = Present Value, F = Future payment (cash flow), r = Discount rate, n = the number of periods in the future.
NPV: Net Present Value
FCF: Free cash flow
r: Discount rate
n: Number of periods
When presented with mutually exclusive options, the decision-making rule is to choose the project with the highest NPV. However, if the alternative project gives a single and immediate benefit, the opportunity costs can be added to the total costs incurred in C0. As a result, the decision rule then changes from choosing the project with the highest NPV into undertaking the project if NPV is greater than zero.
Financial analysts use financial modelingWhat is Financial ModelingFinancial modeling is performed in Excel to forecast a company’s financial performance. Overview of what is financial modeling, how & why to build a model. to evaluate the opportunity cost of alternative investments. By building a DCF modelDCF Model Training Free GuideA DCF model is a specific type of financial model used to value a business. The model is simply a forecast of a company’s unlevered free cash flow in Excel, the analyst is able to compare different projects and assess which is most attractive.
Application of Opportunity Cost
For example, assume a firm discovered oil in one of its lands. 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. 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.
Other Costs in Decision-Making: Incremental Costs
A firm may choose to sell a product in its current state or process it further in hopes of generating additional revenue. For example, crude oil can be sold at $40.73 per barrel. Kerosene, a product of refining crude, would sell for $55.47 per kilolitre. While the price of kerosene is more attractive than crude, the firm must determine its profitability by considering the incremental costs required to refine crude oil into kerosene.
In this example, the firm will be indifferent to selling its product in either raw or processed form. However, if the distillation cost is less than $14.74 per barrel, the firm will profit from selling the processed product. If not, it would be better to sell the product in its raw form.
Other Costs in Decision-Making: Sunk Cost
A sunk cost is a cost that has occurred and cannot be changed by present or future decisions. As such, it is important that this cost is ignored in the decision-making process.
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. Alternatively, the firm can still sell the land for $40 billion.
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.
To learn more and continue advancing your career, see the following free CFI resources:
- Cost Behavior AnalysisCost Behavior AnalysisCost behavior analysis refers to management’s attempt to understand how operating costs change in relation to a change in an organization’s level of activity. These costs may include direct materials, direct labor, and overhead costs that are incurred from developing a product.
- Activity-Based CostingActivity-Based CostingActivity-based costing is a more specific way of allocating overhead costs based on “activities” that actually contribute to overhead costs. An activity is
- WACC FormulaWACCWACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt. The WACC formula is = (E/V x Re) + ((D/V x Rd) x (1-T)). This guide will provide an overview of what it is, why its used, how to calculate it, and also provides a downloadable WACC calculator
- Types of Financial ModelsTypes of Financial ModelsThe most common types of financial models include: 3 statement model, DCF model, M&A model, LBO model, budget model. Discover the top 10 types
Examples of Opportunity Cost
- Someone gives up going to see a movie to study for a test in order to get a good grade. The opportunity cost is the cost of the movie and the enjoyment of seeing it.
- At the ice cream parlor, you have to choose between rocky road and strawberry. When you choose rocky road, the opportunity cost is the enjoyment of the strawberry.
- A player attends baseball training to be a better player instead of taking a vacation. The opportunity cost was the vacation.
- Jill decides to take the bus to work instead of driving. It takes her 60 minutes to get there on the bus and driving would have been 40, so her opportunity cost is 20 minutes.
- This semester you can only have one elective and you want both basket-weaving and choir. You choose basket weaving and the opportunity cost is the enjoyment and value you would have received from choir.
- The opportunity cost of taking a vacation instead of spending the money on a new car is not getting a new car.
- When the government spends $15 billion on interest for the national debt, the opportunity cost is the programs the money might have been spent on, like education or healthcare.
- If you decide not to go to work, the opportunity cost is the lost wages.
- For a farmer choosing to plant corn, the opportunity cost would be any other crop he may have planted, like wheat or sorghum.
- Tony buys a pizza and with that same amount of money he could have bought a drink and a hot dog. The opportunity cost is the drink and hot dog.
- You decide to spend $80 on some great shoes and do not pay your electric bill. The opportunity cost is having the electricity turned off, having to pay an activation fee and late charges. You might also have food in the fridge that gets ruined and that would add to the total cost.
- As a consultant, you get $75 an hour. Instead of working one night, you go to a concert that costs $25 and lasts two hours. The opportunity cost of the concert is $150 for two hours of work.
- David decides to quit working and got to school to get further training. The opportunity cost of this decision is the lost wages for a year.
- Caroline has $15,000 worth of stock she can sell now for $20,000. She wanted to wait two months because the stock was expected to increase. She decides to sell now. The opportunity cost would be determined in two months and would be the difference between the $20,000 and the price she would have gotten if she sold the stock then.
- Jorge really wants to eat at a new restaurant and can only afford it if he does not order a dessert. The opportunity cost is the dessert.
- A business owns its building. If the company moves, the building could be rented to someone else. The opportunity cost of staying there is the amount of rent the company would get.
- When Tobias graduated high school, he decided to go to college. The opportunity cost of going to college is the wages he gave up working full time for the number of years he was in college.
- Mario has a side business in addition to his regular job. If he decides to spend more time on his side business, the opportunity cost is the wages he lost from his regular job.
- Mr. Brown makes $400 an hour as an attorney and is considering paying someone $1000 to paint his house. If he decides to do it himself, it will take four hours. His opportunity cost for doing it himself is the lost wages for four hours, or $1600.
With these examples you can see what opportunity cost means and how it can apply in different situations.
Of course, there are situations where the opportunity cost of a decision is much higher than eating steak tartar instead of pasta. Choosing an investment vehicle is one area where opportunity costs must be more carefully considered.
Any time you invest your money in the stock market, there are certain trade-offs that you must expect. Even the most experienced traders and financial investment professionals have experienced the disappointment of a stock that took a sharp downward turn, despite initially favorable projections. In other cases, a stock could shoot up out of nowhere, with no one predicting its success.
Ironically, the unpredictable nature of the stock market is one of its most consistent characteristics.
This is part of the reason why it is so important to consider the trade-offs you make when you invest in one stock over another. Factoring opportunity cost into your investment decisions allows you to make calculated decisions on where to put your money.
Do you put that extra $5,000 you got from your tax return into Facebook after a small dip, or do you put it into Kodak? No comment.
However, the real cost is not just about the differing returns you will get from a given selection of stocks—it’s also about timing and how long you will have to wait to see your investment pay off. You have $10,000 worth of stock you can sell now for $15,000 but if you wait three months, the stock value is expected to increase even more. But you decide to sell now.
The opportunity cost is going to be the difference between the $15,000 you got when you sold early and the price the stock would have sold for three months later. With investing, time is money.
Maybe you would have made even more money, maybe you would have lost money. Opportunity costs aren’t always readily apparent.
Even investment decisions aren’t always just about how much money you stand to make or lose. In the above example, it’s possible that taking the $5,000 gain now rather than waiting for three months for a greater percent return is the more fiscally sound decision.
Perhaps you could use that $5,000 to pay off a loan or debt early, and avoid fees and compound interest payments. Maybe that $5,000 could be used to invest in another up-and-coming stock that’s expected to rapidly increase in value.
Opportunity Costs: Considerations
When it comes to opportunity cost, these are all factors that you will have to assess. You are faced with two investments that would both give the same return but one would require your money to be tied up for five years versus two years.
The opportunity cost is losing the liquidity of that money for an additional three years.
Perhaps you have to pass up a good investment opportunity during that time because you’re unable to access that money. Maybe you need to pay for something unexpected like a major home repair but that money is tied up and you have to take out a loan to cover it. You need to think about that the next best alternative use of the money.
In these cases, it would likely have been a more financially judicious decision to have liquidated your investment so that those funds were available to use. Otherwise, you could have to assume unnecessary debt.
Having the money and being able to access that money are two different things. If you can leave your money invested in a stock that is slated to perform well without assuming an additional financial burden, that may be the best opportunity for you to get the greatest return.
Implicit and Explicit Costs
There are two kinds of costs that we factor in when looking at opportunity cost: implicit and explicit costs.
Let’s use attending college as an example. The explicit costs of that decision are things like tuition, room and board, and books, things that require a payment.
The time required to attend college is an implicit financial cost. Implicit costs don’t cost us in terms of having to pay for something and is not always easily calculable. Another implicit cost is the money foregone by choosing attending college overworking.
Many people forget about the implicit costs of the decisions they make and instead focus on explicit opportunity costs. Unfortunately, this line of thinking tends to neglect some of the important consequences of financial decisions.
Take a professional training course, for example. It may cost you a few hundred dollars up front, but it may also provide you with the leverage you need to secure a raise or a better position in your professional life.
Over the course of your working years, this may translate into tens or even hundreds of thousands of dollars more than would you would have earned otherwise. In this example, the explicit cost is relatively insignificant, while the implicit cost is dramatic.
How to calculate opportunity cost is usually measured in terms of dollars but your own feelings and values should play a part in all of your decisions, including financial decisions. Because of the complexity of the market and all the various factors that affect your professional and personal life, an opportunity cost formula approach will not always yield the best outcomes.
Throughout your life, you will have to make decisions that affect not only your financial situation but also your overall happiness and personal growth.
It’s been shown that those who have college degrees make more over their lifetime than those who only have a high school diploma. But what if you really don’t want to go to college? What if the only way you can afford it is to take out a lot of student loan debt (it’s not the only way).
Should you still do it, even if it will make you miserable? Probably not. There are plenty of well-paying careers that don’t require a college degree.
On the other hand, it’s possible that you have a great professional trajectory, but you have always wanted to take some college classes or earn your degree. In this case, you will have to take on the cost of tuition and expenses, but you will gain life experience and a sense of accomplishment that you may value more than the capital you will need to invest.
Doing nothing is a choice too. Sometimes we are so overwhelmed by choices and information, we are paralyzed and can’t decide so we just stand pat. This can have terrible consequences. We all know how valuable time is when it comes to investing. Doing nothing has an opportunity cost. Not investing early leaves a lot of money on the table.
Unfortunately, people who are faced with complicated and multifaceted investment decisions often choose to do nothing. By not acting, they can avoid the risks altogether, even though they also forfeit the benefits of a calculated investment.
This may be advantageous in some situations.
If you find yourself in a financial bind, it’s a bad idea to commit a significant portion of your limited resources to a market investment. The investment can go south. Still, if you have the resources necessary to assume some relative risk, you should take advantage of opportunities to make gains.
Careful consideration of options, opportunities, and risks are important. However, don’t get so wrapped up in research that you never act.
In the investment world, timing is crucial—and hesitation can cause you to miss out on great opportunities. It is easy to become so aware of the potential risks that you become afraid to make an investment and put your money on the line.
So how do you get over that paralyzing feeling? Ask yourself three questions.
The number of opportunity costs is almost limitless, a game you could play for hours if you like really boring games. This can be paralyzing and you don’t need to think so deeply about it. You just have to consider opportunity costs in three areas:
What else could you do with this money? Perhaps you could allocate your funds to training or education rather than an immediate investment opportunity and maximize your long-term financial gains.
What else could you do with this time? In some cases, your time is even more valuable than your financial capital. Make sure you understand how you will have to spend your time and the value of time management when you make a personal or professional decision.
Where else could you spend this effort? If a certain stock is likely to provide you with a significant return, but it will require an immense amount of effort to monitor trends and patterns, it might not be worth it in the long run. You might decide that your energy is better spent on your current professional endeavors.
By answering those three questions, you can make the best choice and minimize the impact of opportunity cost.
We hope this little economic concepts lesson, chock full of real-world examples helped fill in the gaps left by our crummy educational system.
As with any major decision, it can be helpful to consult people who you trust—such as a financial advisor, a close friend or a colleague—who can help you walk through the potential outcomes of a financial decision.
Remember that nobody who routinely invests will always come out on top, so don’t write off investing entirely after one bad experience. Instead, use your failures to inform your future decisions. Eventually, increase your financial gains and make your money work harder for you.