What is Opportunity Cost?
When it comes to investing, opportunity cost is the cost of choosing one investment over another.
Opportunity cost is the forgone benefit when choosing one investment over the other.¹
What constitutes opportunity cost?
When evaluating projects for investment, it’s important to consider any hidden costs that are incurred or any potential gains that must be sacrificed. The cost of capital can be considered as an opportunity cost that reflects the interest that a business can earn on cash. If a project delivers returns lower than the cost of capital, it may be better to keep the money as cash instead of investing it. Often, a businesses launch new products that could impact the sales of existing products. Any reduction in sales should be considered an opportunity cost for expanding the business.
Opportunity costs should not be confused with sunk costs. The latter is an expense that cannot be recovered, irrespective of whether a new project is undertaken or not.² On the other hand, the decision to accept or reject a project directly impacts the opportunity cost. For example, costs covering a market survey can be considered a sunk cost, but an economic decision may or may not be taken based on the survey. Irrespective of the survey's outcome, the cost cannot be recovered and is a sunk cost.
Example
Christiano sells chocolate-flavored ice creams in his neighborhood, and he wants to expand his business by offering vanilla-flavored options. Currently, he is selling 100 ice creams per day. After the expansion, he expects to sell 50 chocolate and 50 vanilla ice creams. In short, 50 chocolate ice creams are replaced by 50 vanilla ice creams. Therefore, the revenue from 50 chocolate ice creams is his opportunity cost. If the 50 vanilla ice cream does not generate as much income, it would not be prudent to offer this new variety.
Sources
1. What is Opportunity Cost? The Balance.
2. Sunk Cost. Investopedia.
Please note that this article is for educational and informational purposes and is believed to be accurate and reliable as of posting date but may be subject to change. The example above is hypothetical and is for illustrative purposes only. Alpaca does not provide investment, tax, or legal advice. Please consult your own independent advisor as to any investment, tax, or legal statements made herein.
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