Opportunity Cost: Definition and Example

By Indeed Editorial Team

November 1, 2021

When making a decision, it's important to determine what you could lose by not choosing another option. Opportunity cost helps both individuals and businesses understand the impact of making a certain decision. Learning how to use opportunity cost can help you carefully consider all options available to you so you can make the best choice. In this article, we explain what opportunity cost is and how to determine it, and we include an opportunity cost example.

What is opportunity cost?

Opportunity cost represents what an individual or business may lose when making a decision. You can use opportunity cost in a variety of situations, though it's most common when making financial decisions. Understanding how different financial decisions can help businesses and individuals make investments that return the most money.

For example: A paralegal wants to go attend law school to become an attorney. They need to consider the time and funds they'll spend during school compared to the potential salary they could make as an attorney.

Related: How Opportunity Cost Can Help You Make Better Decisions (with Examples)

How to determine opportunity cost

A common formula for finding opportunity cost is:

Opportunity cost = Return on the option not chosen - Return on chosen option

Using this formula and the below steps, you can calculate opportunity cost:

  1. Assess the situation.

  2. Determine potential gains.

  3. Determine potential losses.

  4. Use the formula.

  5. Make an informed decision.

1. Assess the situation

Before moving forward, assess the given situation. Determine a handful of variables, both positive and negative, that may influence the final decision. In doing so, you can divide the problem into its most necessary components: losses and gains. Gather all of the facts and data you have surrounding the situation so you can make a reasonable decision.

2. Determine potential gains

While the initial gain could be obvious, it's important to consider all possible benefits. Think about short- and long-term financial gains or if you could save more money by making one decision over another. It's also essential to consider any non-financial benefits, including what could make you feel more fulfilled or better position you in your career path.

Large entities may use a team of business analysts to forecast what other potential gains exist.

For example: A company may wish to move to a large city for exposure to bigger markets. The base gain is that the company can make more money. However, analysts determine that business taxes within the destination city have declined. They're projected to continue declining for the next 10 years. Not only will the company gain more business, but it will also be more affordable to headquarter there.

3. Determine potential losses

Determining losses can be more difficult. It may seem simple to determine how much money you gain initially, but long-term returns are harder to find. There are also several other possibilities that you could miss if you make a decision.

For example: If you're deciding if you should accept a job offer, you may want to consider other potential jobs, including their salaries, benefits and growth opportunities. If you're currently working, you also need to consider what you would miss there as well.

By analyzing situations more closely, businesses can make better decisions for their long-term health. It's important to continue looking for avenues in which they may lose money, clientele or employees.

For example: If a company wants to move to a large city for bigger markets, some employees may have a longer commute and decide to find a new job.

Related: Decision-Making Methods for the Workplace

4. Use the formula

Once you have clearly defined your gains and losses, you can determine the opportunity cost. To use the formula mathematically, it's helpful to include gains and losses that can be quantified, like finances.

For example: If you want to accept a job that pays $35,000 per year and leave your current job that pays $32,000 annually, the opportunity cost would be:

Opportunity cost = Return on the option not chosen - Return on chosen option

Opportunity cost = $32,000 - $35,000

Opportunity cost = -$3,000

This means you would lose $3,000 if you stay at your current job.

5. Make an informed decision

At this stage, you should know whether or not the financial gains outweigh the costs. With the figures from the formula and your judgment, you should be able to make a well-informed decision.

Related: Comparative Advantage: Definition and Benefits

Opportunity cost example

In the following opportunity cost example, the previous steps are applied to a realistic scenario:

  1. Assess the situation.

  2. Determine potential gains.

  3. Determine potential losses.

  4. Use the formula.

  5. Make an informed decision.

1. Assess the situation

You recently inherited $50,000. You currently have a job that supports your cost of living and you have no debt. After performing some research, you find that you could put the money in a savings account that accrues 1% interest every year, or you could hire a financial advisor who could potentially get a 5% return per year, which already includes their fee. Since the advisor would be investing in stocks and bonds, it's possible that you could lose money as well.

2. Determine potential gains

In a 10-year projection, you see that putting the money into a savings account could return $5,000, increasing the inheritance to $55,000. If the financial advisor can make a 5% return, the amount would be $25,000, making the inheritance total $75,000.

3. Determine potential losses

With the savings account, you know you'll get a $5,000 return in 10 years. It's possible that you could make $25,000 with the advisor, but it's also possible that you could lose the entire inheritance in the market.

4. Use the formula

You're strongly considering investing with the financial advisor since you have no debt and you can support your cost of living. You use the following formula:

Opportunity cost = Return on the option not chosen - Return on chosen option

Opportunity cost = $55,000 - $75,000

Opportunity cost = -$20,000

It's possible that if you don't choose to invest, you could lose $20,000.

Related: 12 Ways To Make Better Decisions

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