What is Opportunity Cost?
Opportunity Cost Definition
Opportunity cost is the implicit cost incurred by missing out on an investment, either with one’s time or money. Because resources are finite, investing in one opportunity causes another opportunity to be forgone.
Example of Opportunity Cost
Company ChooseRight assesses an investment in a $100,000 machine that will net a profit of $150,000 over its useful lifetime of 10 years. In isolation, the investment is perceived to be wise because it nets a positive return. However, before finalizing the investment in the new machinery, company ChooseRight estimates the opportunity cost if the funds were invested elsewhere. They estimate a $200,000 return over the next 10 years by investing in an employee training program, expanding the marketing budget, and upgrading an outdated payroll system. Company ChooseRight therefore decides that although the investment in new machinery would return a profit, the opportunity cost of the investment suggests that the funds should be invested elsewhere.
Informing Decisions with Opportunity Cost
Businesses often establish a minimum internal rate of return, or IRR, based on historical and future opportunity costs. Future estimated cash flows are discounted by a company’s IRR to calculate the net present value of an investment. If the net present value of an investment is positive, the estimated return is greater than its opportunity cost. Therefore, a positive net present value suggests funds invested in this opportunity provide a return greater than if the funds were invested elsewhere.
Opportunity cost can be used to inform any decision, from investing in a security to what leisure activities one does during their free time.