What Is Opportunity Cost? (Plus How To Calculate It)

By Indeed Editorial Team

Published 4 May 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Opportunity cost is an important tool that helps in business decision-making. It helps you identify the cost or value of the next best available alternative when making purchase decisions. Learning about opportunity costs can help improve the effectiveness of your professional and personal decisions. In this article, we answer, 'What is opportunity cost?', discuss how to calculate it with an example, understand when to use it and explain the disadvantages of opportunity cost calculations.

What is opportunity cost?

Understanding 'What is opportunity cost?' simplifies the decision-making processes and can help identify the best available option when choosing between several items. It is the value that you lose or gain while choosing between two alternatives. You can use it while making business, investments, career or personal decisions. Opportunity cost helps quantify your choices and consider other influential factors you may generally overlook. Though this is an excellent tool for improved decision making, people often ignore it, as the opportunity cost of choosing something is not evident outrightly and requires calculation and analysis.

For example, a college student wants to pursue higher studies and join a multinational company. He can go to college or join a company with his current qualifications. Here, the student can compare the money he may spend in college with his earnings. Similarly, he can compare the time required to complete the degree with how much time the job may take. This comparison can help him decide which option to choose.

How to calculate opportunity cost

Follow these step-by-step instructions to calculate opportunity cost:

1. Understand the situation

Before calculating opportunity cost, it is essential to understand and assess all the options you have in the current situation. Identify different variables from all the options that can influence your decision making. Once you have the variables, you can determine which of them you can categorise as losses and gains.

For example, say you have the option to drive to your workplace or take a bus. Driving takes 30 minutes, and taking the bus can take up to an hour. You can assess your situation and identify the variables common to both, such as urgency, the time to reach the office, convenience and comfort to decide which mode of transportation to take.

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2. Identify the potential gains

Once you have all the variables, identify the gains when you make a choice. Sometimes, the initial gains may look obvious, such as the money you can save, but there may be several other benefits in choosing an option. Instead of just considering the immediate short-term benefits, also look at the long-term benefits of the choice. Quantify the benefits that you can but also take into consideration other intangible benefits such as mental health, more time to spend with your family and extra time to exercise.

For instance, say that you have a job opportunity at your current employer's competitor's firm. You are getting a higher salary and the option to work remotely. However, you are being considered for a promotion at your current job and may receive a substantial raise. In this case, you may receive a raise if you stay at your current job, but your mental health may be better at the other job. You may go to the next level in the hierarchy at your current organisation, but you may be a part of better work culture at the other.

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3. Identify potential losses

Similar to identifying potential gains of making a choice, recognise the potential losses of choosing an alternative. Look at the short-term losses and the long-term losses. Some losses, such as a reduction in salary, may be apparent, but there may also be other crucial factors that you miss if you choose a particular alternative.

For instance, if you are contemplating moving your business to a new city or expanding operations, you may have to compare several factors like local regulations, availability of raw material and customer preferences. While the apparent loss may be the cost higher cost of expansion, some other losses are the increased taxes, restricted market and challenges of trying to enter a new market. If you choose to expand in the current city, you may have a familiar market, but you lose the chance to expand into new territory and earn a higher market share.

4. Use the mathematical formula to calculate the opportunity cost

Once you know the potential losses and gains, you can calculate the opportunity cost by using the mathematical formula. The formula for calculating opportunity cost is as follows:

Opportunity cost = Return on the option not chosen - Return on the option chosen

For example, say you have two job offers in two different countries. If you choose the job in country A, you get ₹10,00,000 a year, and if you choose job B, you get ₹15,00,000. Based on these numbers and the given formula, the opportunity cost of choosing job A is ₹5,00,000. You can lose ₹5,00,000 if you choose job A, but there are other factors such as cost of living or distance to the workplace that can influence your choice of selecting the job. If necessary, you make this calculation using different variables to make an informed decision.

5. Make a well-informed decision

Once you have the opportunity cost of making a decision, it is vital to ensure that the gains are higher than the losses. It is important to remember that not all losses or gains are financial. Use your judgement to evaluate the other factors that affect your decision.

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An example of opportunity cost

Here is an example to help you understand opportunity cost:

You start receiving ₹10,000 extra each month from your investments. You have the option of saving all of this money each month or spending half of it and saving the rest of it. If you continue saving all the money for 10 years, you can have an additional ₹12,00,000 by the end of the ten years. But if you save just half of it, you can only have an additional ₹6,00,000. Additionally, if you spend the money on luxuries such as eating out more often, it may affect your health.

By saving more money, you can have some extra money available during emergencies or when you want to make an expensive purchase, like a house or car. You can also use the funds to invest in your professional career. So, while there are some obvious potential gains, there are also some underlying gains and potential losses of choosing one alternative over the other. Suppose you select the option of saving half of your money, the opportunity cost as calculated by the formula is ₹6,00,000. In this example, ₹6,00,000 is the opportunity cost of choosing the second option.

When to use opportunity cost calculations

You can use opportunity cost calculations whenever you are making a choice between two or more alternatives. It helps you identify the most viable decision and also encourages you to look at critical variables. For example, while evaluating two job offers based on salary, the opportunity cost may encourage you to consider factors beyond money to justify whether choosing a job with a higher salary is the most profitable decision.

Drawbacks of opportunity cost calculation

Though opportunity cost can be a great tool that helps in decision making, it may have some drawbacks that prevent it from being useful in every situation. Opportunity cost calculations are most common when analysing future situations, but sometimes, there may not be enough time to evaluate the choices using the formula. For example, you may not be able to use the formula immediately while choosing between two brands of cereal at a departmental store.

Opportunity cost calculations use assumptions about the future, and the actual situations may vary. In cases with a high level of variability, this formula may be ineffective. While calculating the opportunity cost of any decision, there may be several other factors that influence your decision, such as time, energy spent, state of mind and health. It may be challenging to quantify such variables and include them accurately in the formula, as the opportunity cost formula only includes the return on the forsaken option and the return on the chosen option.

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