3 12: The Concept of Opportunity Cost Business LibreTexts

“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. Opportunity costs can be easily overlooked because sometimes the benefits are unrealized, and therefore, hidden from view. Generally speaking, the stronger the liquidity, versatility, and compatibility of the asset, the less its sunk cost will be. If the business goes with the securities option, its investment would theoretically gain $2,000 in the first year, $2,200 in the second, and $2,420 in the third. Hupana currently buys the soles that go on their awesome running shoes from a supplier premade and ready to attach to their shoes.

• The economic view of the world is that people acquire puppies because the value they expect exceeds their opportunity cost.
• The same process of selecting between payment and action may be employed to monetize opportunity costs in other contexts.
• Room and board would not be a cost since one must eat and live whether one is working or at school.
• Investors might use the historic returns on various types of investments in an attempt to forecast their likely returns.
• Room and board are a cost of an education only insofar as they are expenses that are only incurred in the process of being a student.

Hupana wants to look at the option of making the soles in house, because they have some empty space in their building, that would be a perfect fit for the equipment needed to make the soles. Just to make this simple, let’s assume Hupana already owns the equipment to make the soles. Please include what you were doing when this page came up and the Cloudflare Ray ID found at the bottom of this page. This website is using a security service to protect itself from online attacks. There are several actions that could trigger this block including submitting a certain word or phrase, a SQL command or malformed data.

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According to the United States Department of Transportation, more than 800 million passengers took plane trips in the United States in 2012. Since the 9/11 hijackings, security screening has become more intensive, and consequently, the procedure takes longer than in the past. Say that, on average, each air passenger spends an extra 30 minutes in the airport per trip. Economists commonly place a value on time to convert an opportunity cost in time into a monetary figure. Because many air travelers are relatively highly paid businesspeople, conservative estimates set the average “price of time” for air travelers at $20 per hour. Accordingly, the opportunity cost of delays in airports could be as much as 800 million (passengers) × 0.5 hours × $20/hour—or, $8 billion per year.

However, the cost of the assets must be included in the cash outflow at the current market price. Even though the asset does not result in a cash outflow, it can be sold or leased in the which one of these represents an opportunity cost? market to generate income and be employed in the project’s cash flow. The money earned in the market represents the opportunity cost of the asset utilized in the business venture.

Use of opportunity cost

Since resources are limited, every time you make a choice about how to use them, you are also choosing to forego other options. Economists use the term opportunity cost to indicate what must be given up to obtain something that’s desired. A fundamental principle of economics is that every choice has an opportunity cost. If you sleep through your economics class (not recommended, by the way), the opportunity cost is the learning you miss. If you spend your income on video games, you cannot spend it on movies. If you choose to marry one person, you give up the opportunity to marry anyone else.

Remember, they already own the equipment to make them, but that is a sunk cost, as there is no way to recoup that cost anyway. For example, the money you’ve already spent on rent for your office space is a sunk cost. But the funds you haven’t spent on office furniture yet would be considered an opportunity cost because you haven’t actually spent the money yet. The opportunity cost of choosing to invest in Company A versus Company B is 10% minus 6%. With that choice, the opportunity cost is 4%, meaning you would forgo the opportunity to earn an additional 4% on your funds.

Learn more about this definition and others

The definition of opportunity cost is the potential gain lost by the choice to take a different course of action when considering multiple investments or avenues of business. When weighing two or more courses of action, the opportunity cost refers to the value of the option you necessarily sacrifice in order to pursue the option you decide upon. Regardless of which option is chosen, there will be a cost assigned to the option that is forgone—that is the opportunity cost.

• Having examples can help to achieve a clearer understanding of the concept of opportunity costs.
• Using the simple example in the image, to make 100 tonnes of tea, Country A has to give up the production of 20 tonnes of wool which means for every 1 tonne of tea produced, 0.2 tonnes of wool has to be forgone.
• The opportunity cost of choosing the guest room option over the gift shop option is $6,900 annually.
• For example, the money you’ve already spent on rent for your office space is a sunk cost.
• Because opportunity cost is a forward-looking consideration, the actual rate of return (RoR) for both options is unknown at that point, making this evaluation tricky in practice.
• Since people must choose, they inevitably face trade-offs in which they have to give up things they desire to get other things they desire more.

In other words, by investing in the business, the company would forgo the opportunity to earn a higher return—at least for that first year. Say the owner could have invested the $65,000 remodeling costs for the gift shop in The Home Depot stock when it was trading at $152.20 on March 20, 2020, but instead chose to invest it in her own business. On March 19, 2021, when The Home Depot stock was trading at $289.10, her 427 shares would have been worth $123,466, an increase of $58,465. That makes the opportunity cost of remodeling the room almost $30,000 since she could have made $58,465 instead of $28,800. Of course, at the time, she had no way of knowing that The Home Depot stock would rise so high so fast, and no assurance that it would continue to do so or not drop dramatically in the near future. 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.