opportunity cost

opportunity cost

The best alternative that is forgone because a particular course of action is pursued. An example is the interest income that is given up when large balances are kept in a checking account. Likewise, purchasing a home means that less money is available for another investment.

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Opportunity Cost

The difference in return between an investment one makes and another that one chose not to make. This may occur in securities trading or in other decisions. For example, if a person has $10,000 to invest and must choose between Stock A and Stock B, the opportunity cost is the difference in their returns. If that person invested $10,000 in Stock A and received a 5% return while Stock B made a 7% return, the opportunity cost is 2%. Opportunity cost can be conceptualized as the amount of money one could have made by making a different investment decision.

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Opportunity cost. When you make an investment decision, there is often a next best alternative that you decided not to take, such as buying one stock and passing up the opportunity to buy a different one.

The difference between the value of the decision you did make and the value of the alternative is the opportunity cost.

If you decide to invest in a risky stock hoping to realize a high return, you give up the return you might have earned on a bond or blue chip stock. So if the risky stock fails to perform, and you only make 3% on it when you might have made 6% on a blue chip, then the opportunity cost of the risky investment is 3%.

Of course, if your stock pick pays off, there will have been no opportunity cost, because you will make more than the 6% available from the safer investment.

Businesses must also consider opportunity costs in their decision-making. If a company is considering a capital investment, it must also consider the return it would earn if, instead of going ahead with the capital project, it invested the same amount of money in some other way.

In general, a business will only make a capital investment if the opportunity cost is lower than the projected earnings from the new project.

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opportunity cost

The value of the opportunity given up in order to take advantage of the one you decide to take.The classic opportunity cost evaluation is the “rent or buy decision.”If a person buys a home,the person gives up the opportunity to invest the down payment money in something else. Because mortgage payments and maintenance costs are usually higher than rent, the new homeowner must also spend more money each month rather than investing it. On the other hand, the analysis must take into account tax savings because of the deductibility of home mortgage interest payments.Conducting an analysis of opportunity costs in the “rent versus buy”situation might cause one to buy immediately,buy later,or decide not to buy at all for the foreseeable future.Ginnie Mae has an excellent rent versus buy calculator at www.ginniemae.gov.

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Opportunity Cost

What Does Opportunity Cost Mean?

(1) The cost of an alternative action that must be forgone to pursue a certain action. Put another way, the benefits an investor could have received by taking an alternative action. (2) The difference in return between an investment that was undertaken and one that was passed up. For example, say a person invests in a stock and it returns a paltry 2% over the year. In placing his or her money in the stock, the investor gave up the opportunity of another investment, say, a risk-free government bond yielding 6%. In this situation, the opportunity costs are 4% (6% - 2%).

Investopedia explains Opportunity Cost

(1) The opportunity cost of going to college is the money the student would have earned by working instead. On the one hand, the student loses four years of salary while getting a degree; on the other hand, the student hopes to earn more during his or her career, thanks to education, to offset the lost wages. Put another way, if a gardener decides to grow carrots, his or her opportunity cost is the alternative crop that might have been grown instead (potatoes, tomatoes, pumpkins, etc.). In both cases, a choice between two options must be made. It would be an easy decision if one knew the outcome; however, the risk that one could receive greater “benefits” (monetary or otherwise) with another option is the opportunity cost.

Related Terms:
• Capital Structure
• Earnings
• Gross Profit Margin
• Net Sales
• Profit and Loss Statement