What is opportunity cost?

Have you ever wanted to make better financial decisions, but weren’t sure how? Luckily, you can use opportunity cost to help you. Calculating opportunity cost is beneficial for your personal finances, households, and small businesses.

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The definition of opportunity cost

In economics, opportunity cost weighs the money or benefits that one can gain when selecting one option over the other. Using opportunity cost to make your financial decisions can determine whether you make or lose money. Opportunity cost isn’t necessarily about choosing the cheaper option—using opportunity cost will help you determine which option will ultimately improve your finances.

Here are some examples of how you can use opportunity cost in your everyday life:

• Determining how much money you would lose if you stayed at your current job versus starting your own business
• Determining whether you would make more money by selling your stocks now or waiting
• Deciding whether you should accept the job offer that pays more, or accept the job offer that pays less but has better benefits
• Determining how much money you would lose by hiring a part-time nanny and working less, or hiring a full-time nanny and working more

How to calculate opportunity cost

Opportunity cost is easy to calculate. Use this formula to calculate opportunity cost:

Opportunity cost = Return on the second-best option – Return on the option chosen

Here’s an example of how you can apply the opportunity cost formula to your financial decisions. Janet is trying to determine the opportunity of cost between University A and University B. University A costs $50,000 per year, but University B, which she is more interested in attending, costs $60,000 per year. If Janet were to use the opportunity cost formula, it would look like this:

University A ($50,000) – University B ($60,000) = $10,000

This means that Janet’s opportunity cost would be $10,000 if she chose to attend University B instead of University A. In other words, she would be losing $10,000 by attending University B. She would save more money by attending University A. But if she prefers to attend University B, there may be intangible benefits that could justify the extra cost.

Here’s another example of the opportunity cost formula in action. Taylor is trying to determine if he made the right decision when he bought stocks. He was stuck between buying stocks from two companies: Company A and Company B. Taylor chose to buy stocks from Company A. Last year, Company A returned 2% on stocks, while Company B returned 5% on stocks:

5% (Company B) – 2% (Company A) = 3%

Taylor’s opportunity cost was 3%. In this case, he lost money by purchasing stocks from Company A.

The disadvantages of using opportunity cost

A disadvantage of using opportunity cost to make financial decisions is that it depends on assumptions. Opportunity cost doesn’t account for unforeseen circumstances, and costs can change at any time. Let’s say that Janet used the opportunity cost formula and realized she should attend University A instead since it was cheaper. Tuition increases all the time, and by her sophomore year, University A increased its tuition to $70,000 a year while University B kept its tuition at the same price. In this case, she might as well have attended University B.

Opportunity cost vs. trade-off

Many people confuse opportunity cost with trade-offs. The difference is that a trade-off analyzes what benefits are exchanged: in a trade-off, you give up one or more benefits to get another. Instead, opportunity cost only compares the value of two or more options. Additionally, there is no formula for a trade-off, while there is a numerical formula used for opportunity cost.

Opportunity cost vs. sunk cost

Sunk costs are often confused with opportunity cost. However, sunk costs are different because they evaluate cash that was already spent and is unrecoverable. On the other hand, opportunity cost evaluates potential earnings that weren’t made because the money was invested in something else.

Understanding opportunity cost—as well as other financial decisions—can assist you with monthly budgeting and how to spend and save wisely. For more budgeting tips, Microsoft 365 can help.