What is an opportunity cost?
Opportunity cost in finance is a measure of the potential benefit lost when one choice of action or investment is made over another. It focuses on real costs as opposed to merely looking at the financial amount spent and ignores other considerations such as time, energy, and effort.
How to calculate opportunity cost?
Understanding the concept of opportunity cost is essential for optimal decision-making. Opportunity cost is calculated by subtracting the expected benefit from an alternative course of action from the benefit of your chosen action.
For example, if you decide to go on vacation and incur INR 1,000 in expenses, that would be your out-of-pocket cost for the vacation. However, if you chose to stay home rather than go on vacation, then the opportunity cost would be what you could have done with that INR 1000 instead (e.g., paying off debt or putting it into savings).
Importance of Opportunity Cost
Opportunity cost is the value of what one can gain by choosing one thing over another in any decision-making scenario. Without understanding opportunity cost, it can be difficult to understand which options are most profitable in both the long and short term. Being aware of the opportunity cost associated with each option helps guide investment decision-making intelligently, as well as economically. This information can be especially useful when trading goods or services or investing money since knowledge of opportunity cost can help identify potential mistakes that would decrease profits.
Opportunity cost vs Sunk Cost
Understanding the difference between opportunity cost and the sunk cost is critical to making better decisions in both business and everyday life. Opportunity cost applies to decisions involving the currently available resources and considers all of an individual's or business' options when making a choice. The alternative is giving up when making a decision has an opportunity cost associated with it.
Sunk costs, on the other hand, are irrevocable past financial outlays that have already occurred. They don't factor into decision-making as they can't be recovered compared to future losses which could be avoided by weighing opportunity costs. Thus, while it may appear counterintuitive, sunk costs should not be taken into consideration when evaluating the potential outcomes of a decision.