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This article was co-written by Michael R. Lewis. Michael R. Lewis is a retired Texas executive, entrepreneur and investment advisor. He has over 40 years of experience in Business & Finance, including the position of Vice President of Blue Cross Blue Shield of Texas. He holds a BBA in Industrial Management from the University of Texas at Austin.
There are 10 references cited in this article that you can view at the bottom of the page.
This article has been viewed 62,203 times.
Opportunity cost is defined as what you sacrifice to make another choice. This concept compares what you lose with what you gain based on your decisions. Opportunity costs can be measurable, or can be very difficult to quantify. Understanding the concept of opportunity cost can help you make more informed decisions.
Steps
Calculate opportunity cost
- For example, let’s say your company has $100,000 in side funds, and you have to decide whether to invest in stocks or buy production equipment.
- If you decide to invest in a stock, you may gain a profit on that investment, but at the same time you will lose the profit that could have been earned from the purchase of new production equipment.
- On the other hand, if you decide to buy new production equipment, you can also benefit from contributing to increased sales, but you will lose the profits earned from investing in stocks.
- Opportunity cost = most attractive option – option chosen.
- 12,000 wonUSEASY−10,000 wonUSEASY=2,000 yenUSEASY{displaystyle 12,000USD-10,000USD=2,000USD}
- Thus, the opportunity cost of choosing to buy new equipment is $2,000.
Evaluate business decisions
- The company must evaluate the opportunity cost of choosing between debt and equity.
- If the company chooses to borrow money to support its growth, the money to pay off the loan principal and interest will no longer be invested in securities.
- The company must evaluate the opportunity cost to ensure that the expansion from the borrowed money provides enough returns in the long run to justify forgoing the investment in securities. [3] X Research Sources
- Companies have to make decisions about how to allocate resources to different projects. If you spend time on one project, there won’t be time for another.
- For example, suppose a furniture company has 450 hours of work per week, and to complete one recliner, it takes the company 10 hours of work, that is, the company will produce 45 pieces per week. The company decided to produce 10 sofas a week, each taking 15 hours to complete. Thus, the company will take 150 hours to produce 10 sofas.
- Excluding the time it takes to make the sofa, the company has 300 working hours left, and so can only produce 30 recliners. Therefore, the opportunity cost of 10 sofas is 15 recliners (45−30=15){displaystyle (45-30=15)} .
- For example, let’s say you are a chef earning $23 an hour and you decide to quit your job to open your own restaurant. Before making money from this new business, it will take you a long time to buy food, hire employees, rent a house and open a restaurant. You may eventually make money, but the opportunity cost will be the amount that would be paid if you didn’t quit during this time.
Evaluate individual decisions
- Calculate the financial opportunity cost. Let’s say you work from home and earn $25 per hour. If you hire a maid, you will have to pay 20 USD/hour. The opportunity cost of doing housework yourself is $5/hour (25USEASY−20USEASY=5USEASY){displaystyle (25USD-20USD=5USD)} .
- Calculate the opportunity cost of time. Let’s say you spend 5 hours every Saturday doing laundry, grocery shopping, and cleaning. If you hire a maid to clean and do the laundry once a week, it will only take you 3 hours on a Saturday to complete the laundry and grocery shopping. Now, the opportunity cost of housework is 2 hours.
- The total tuition fee is the amount you have to pay ($4,000) plus the government subsidy ($8,000), which is $12,000.
- The opportunity cost of not working is $20,000.
- So the opportunity cost of a year of college is 12,000 wonUSEASY+20,000 wonUSEASY=32,000 wonUSEASY{displaystyle 12,000USD+20,000USD=32,000USD} .
- Other opportunity costs associated with going to college include the value of 4 years of real work experience, the value of time spent studying instead of other activities, or the value of things you can afford. buy with the money you pay for tuition or the benefits that money can bring if you invest. [8] X Research Sources
- On the flip side, however, the average weekly income of someone with a college degree will be $400 more than someone with a high school diploma. If you decide not to go to college, the opportunity cost is worth it. income increases in the future. [9] X Trusted Source US Bureau of Labor Statistics Go to source
- If you choose to buy a new car over a used car, the opportunity cost is the amount of money you could save if you bought the used car and how you use that difference.
- Let’s say you decide to use your tax refund to travel with your family instead of saving or investing. Thus, the opportunity cost is the profit value of the savings or the return on investment.
- Remember that value is not necessarily money or tangible property. So when making your decision, you should also consider how your choices will affect your intangible assets, like your happiness, health, and even your free time.
This article was co-written by Michael R. Lewis. Michael R. Lewis is a retired Texas executive, entrepreneur and investment advisor. He has over 40 years of experience in Business & Finance, including the position of Vice President of Blue Cross Blue Shield of Texas. He holds a BBA in Industrial Management from the University of Texas at Austin.
There are 10 references cited in this article that you can view at the bottom of the page.
This article has been viewed 62,203 times.
Opportunity cost is defined as what you sacrifice to make another choice. This concept compares what you lose with what you gain based on your decisions. Opportunity costs can be measurable, or can be very difficult to quantify. Understanding the concept of opportunity cost can help you make more informed decisions.
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