Opportunity Cost: Definition, Formula And Examples

Each decision you make — yes, even with your finances — comes with an opportunity cost.

Opportunity cost is what we give up when we make decisions, whether it’s going to the gym instead of going out with friends, or paying for a concert ticket instead of the books on your wish list.

Understanding opportunity cost can help you make better, more conscious decisions about your finances – and your life.

What Is Opportunity Cost?

Opportunity cost is an economic term that helps us understand what we’re giving up when we choose one option over another. In other words, opportunity cost is the value of something we’re giving up. Because none of us have unlimited time or money to do all the things we want with our lives, we’re constantly making tradeoffs that we think will bring us the most desirable outcomes. When you make a choice, you’re usually giving something else up.

In finances, it could mean that spending money on one item means you won’t be able to spend that money on anything else. In investing, it refers to what you could have earned if you had put money in another investment instead of the one you ultimately chose.

How Does Opportunity Cost Work?

Opportunity costs play a significant role in your finances, including your investment decisions.

Some of these tradeoffs could include earning less in a less risky investment in the stock market, but the tradeoff is that you’re earning a consistent return. Or, you decide to go on a family vacation and use your credit card. Although you get to enjoy yourself in the moment, the tradeoff is that you may end up with more debt.

Common ways people determine their opportunity costs is through factors such as scarcity, risk tolerance, explicit costs and implicit costs.

Risk Tolerance

Your level of risk tolerance refers to how much risk you’re willing to take on when investing.

Investors with a high level of risk tolerance are more likely to utilize an aggressive investing strategy, where they have the potential to gain a lot of money but also risk losing a lot of money.

Investors with a low tolerance for risk typically take a more conservative investment strategy, putting their money in investments that are reliable and stable but typically see lower returns. These investors might not earn as much as more aggressive investors, but they’re also less likely to lose a bunch of money in their investments.

With many decisions, including investment decisions, your actual opportunity cost is only obvious in retrospect. You can’t know for certain if one investment will perform better than another, or if one decision will be more beneficial than its alternative.

Scarcity

Since we have a lot of wants but a finite amount of resources, we need to make choices that best suit us. Sadly, there are trade-offs that end up happening. Taking opportunity cost into account when we make decisions can help us make the most of our limited, or scarce, resources.

Explicit Costs

These are direct costs you'll need to pay when making financial decisions. For instance, investors will look at management or upfront fees when purchasing mutual funds or options. Or, you're comparing personal loans to look at origination fees and interest costs.

For example, if you decide to take out a loan and there is a $50 application fee, your explicit cost is $50. This doesn’t include the amount you’ll pay in interest throughout the life of your loan.

Implicit Costs

Implicit costs aren't direct payments but instead are lost opportunities -- think the inability to make more money because you've used up a resource. For example, if you decide to purchase a second car, the implicit cost is that you could have used the money to invest in additional shares of stocks.

How To Calculate Opportunity Cost

There’s no exact way to measure opportunity costs, especially implicit ones.

Instead you can try calculating it using the difference between what you could gain and what you give up when you choose one option over another.

Try the following formula:

Opportunity cost = [return on option you gave up] - [return on option you chose]

Say you have $10,000 to invest in the stock market. Investment A has a projected rate of return of 7% while Investment B is projected to see a 12% rate of return.

Based on these projections, you’d be forfeiting 5% in returns by choosing Investment A over Investment B:

12% - 7% = 5%

Over the course of 5 years, if you chose Investment B, you’d have a little over $17,600. In that same time span, Investment A would have you at a little over $14,000. Because you picked Investment A, you missed out on around $3,600.

Opportunity Cost Examples

Here are some additional examples of opportunity costs as it pertains to your professional and personal life.

Example 1

Let’s say you want to expand your business and aren’t sure whether to create a new product line or increase production on a current product. To choose the latter, you estimate you will need to invest an additional $100,000 in labor and materials. To create a new product line, you estimate it’ll cost $300,000.

Though the risk may be higher, the new successful product line could end up earning $1 million over the next 5 years – profiting $700,000. Meanwhile, increased production for an existing product earns you $500,000 – profiting $400,000. Here, the opportunity cost in choosing to increase production instead of creating a new product is around $300,000 that you could have missed out on earning.

Example 2

Having a college degree can help boost your future earnings, meaning you may earn more income over the course of your life if you go to college than if you don’t. However, if you’re going to school full time, you typically can’t also work full time. The income you would have earned working full time is an opportunity cost of attending college full time.

For example, you spend $80,000 total to attend school and get a 4-year degree. During that time, you could have worked full time and earned $22,000 per year, or $88,000 over 4 years. When all is said and done, not only will you have spent $80,000, you’ll also have given up an additional $88,000 in potential income.

On the flip side, you’re getting a degree in a high-paying industry that requires workers to have a bachelor’s degree. As soon as you graduate, you’re offered a job with a salary of $75,000. If you stay in this job until you retire in 40 years, you’ll have probably earned a few million dollars. 

Compare this with your earnings if you worked your $22,000 per year job for 44 years (this includes the 4 years you gained by not going to school) – over that time, you’ll have earned a little less than $970,000.

Opportunity Cost FAQs

The following are some frequently asked questions about opportunity costs.

What’s the difference between opportunity cost and sunk cost?

Opportunity cost is money or value you could have earned in the future whereas sunk costs is money you've already spent.

Is opportunity cost a real cost?

Yes, opportunity costs are real, even if they don't show up explicitly in your budget or your business financial statements. Though it's fairly abstract, it's an important concept to incorporate when making decisions.

Why does opportunity cost analysis matter?

Opportunity cost analysis matters because it’ll help you take the time to make the best decision for your situation.

What’s an example of opportunity cost?

Let’s say you got $500 for your birthday and you’re not sure what to spend it on. You can purchase a course that will help you gain skills to increase your chances of a promotion (and earn a lot more in the future) or invest it in a bond that earns you 2.5% each year. The opportunity cost would be what you could be earning throughout your career versus the returns you’ll get from investing in the bond. 

The Bottom Line

You can utilize opportunity cost to help you make better financial, personal and business decisions. But opportunity cost isn’t a magic crystal ball, and it can’t always tell you whether what you’re giving up is worth what you gain. You’ll still have to make decisions based not only on what makes financial sense, but also on what suits your needs, wants and desires.

To help you make better financial decisions, consider downloading the Rocket Money℠ mobile app. This tool lets you view all your accounts in one place so you can easily calculate potential opportunity costs when you’re about to use your money.

Create an account on the Rocket Money app today.