The opportunity cost is a major concept in economics whether you’re an individual or a business. To put it simply, the opportunity cost refers to the potential gains you’ll miss out on when you choose one alternative over another. It’s the amount you will lose when you go from one property to another. You can utilize opportunity cost to see the outcome of each investment to minimize losses and maximize returns.
Although most financial reports won’t show the opportunity cost, business owners and investors are keen on calculating it to make better decisions. The formula for opportunity cost is very plain, as the reasoning behind it is simple.
Opportunity Cost Formula
Opportunity Cost equals Return on Past Option minus the Return on Selected Option.
Here is a plain example to better understand the opportunity cost in both business and investments.
Assume you’re a business owner thinking about investing in cryptocurrencies that will bring in 20 percent of gains over a period of one year. You also have the option to invest back that money into your business to purchase new equipment to lower your operational costs. If you reinvest in your business, you will make a 15 percent return over the same period of time. The math is simple. 20 – 15 percent, equaling to 5 percent.
What the opportunity cost teaches us is by reinvesting the money back into your business, you forgo the 5 percent of gains from investing in cryptocurrencies.