What is an opportunity cost?
Created on 20 Apr 2019
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Updated on 08 Oct 2020
Opportunity cost refers to an unrealized loss incurred due to missed opportunities. Opportunity cost is the cost of not choosing the next best available alternative.
In simple words, opportunity cost refers to the cost of spending the time, energy, and finances on doing one thing instead of others. If the resources are unlimited, then it may lead to no loss of opportunity cost.
Example: Suppose a businessman Y has a sum of 2,00,000 Rs, that can be used in two different ways. One is that he can invest it in opening new offices which will increase his reach with an expected increase in profits of Rs. 1,50,000. The other option is that he starts up a new manufacturing unit from it which will help him earn a profit of 1,00,000 Rs per annum.
Now, businessman Y is keen on making more money and chooses to go with the first option. So, he decides to open new offices all over the country. Now, the opportunity cost of Rs. 1,00,000 which arouse as a result of foregoing the opportunity of starting a new manufacturing unit is called as Opportunity cost.
There are other few key cost factors which are implicit cost and explicit cost.
Implicit cost: The implicit cost refers to the cost incurred to provide inputs into the business. It is a cost that has occurred but not reported as an expense in the business. It does not involve cash payments and is the opposite of Explicit cost.
Explicit cost: Explicit cost is the pocket cost that is shown after the payments have been made. It is the cost that is incurred during the production of products or services. In other words, the explicit cost is identified expenses that have been accounted for officially.
Note: When an opportunity cost is shown in the form of money then it is often referred to as the Economic cost.
So, the equation to calculate the Opportunity/economic cost goes as follows:
Economic cost = Explicit Cost + Implicit Cost
For any company, the cost mentioned after accounting on the balance sheet is called the Explicit cost.
The accounting profit of any company is calculated by deducting the explicit cost from the total revenue.
Moreover, the explicit cost is always smaller than the opportunity cost, as opportunity cost also includes the implicit cost.
What is the importance of understanding the opportunity cost?
It is essential to learn opportunity cost as it plays a significant role in handling your finances. Do you know that every choice that you make in your life has an opportunity cost attached to it (even if you are not aware of it)?
Each one of us is aware of the direct cost of living that we pay for each day. Be it gas, petrol, food, grocery, movie tickets, traveling; we are all aware of the amount of money we pay to avail these essential services. However, there is an indirect cost attached to each bill that we pay. No, I am not talking about the hidden charges or taxes of any sort; instead, I am referring to the opportunity cost.
Unseen costs: When you pay Rs. 15,000 each month as your house rent, have you ever thought the opportunity cost attached to it?
Now, let us list the things that may come across as the opportunity cost to you.
• You could have saved this 15,000 each month to get a lump sum amount which you can use to travel to your dream location on holiday.
• Or, you could use the money to shop for new dresses each month.
• Or, you could have used the same money for entertainment and outings, etc.
So, all these options account for the opportunity cost. So, opportunity cost does not refer to just monetary forgone profits, but it also includes the pleasure, the contentment, or psychological satisfaction that you have missed by not choosing to do the other activity.
So, an understanding of opportunity cost is highly important in handling your finances. As without having the knowledge of opportunity cost, you would never understand the missed profits or earnings that are foregone by not using alternative options.
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