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Opportunity Cost: Definition, Function, and Calculation Method

Opportunity cost is the comparison of an economic option with other best options. Many in finance and economics use this analogy when comparing investment options. By measuring the impact of choosing one investment over another. Opportunity cost is the loss or gain of making a decision.

If forced to choose between buying and selling shares, you can make an immediate profit on the sale but lose out on future profits. As an accountant or financial specialist in accounting, you must understand what opportunity costs are and how they occur.

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Definition of Opportunity Cost 

Opportunity cost is the value of the loss you experience when choosing an option. Usually, when you make a decision, there is a feeling that the outcome will be better regardless of the consequences. As an investor, this cost implies that your investment decisions will always result in an immediate loss of profit in the future.

Opportunity costs develop as a result of the choices that individuals, businesses, and society make in the face of scarcity. As you know, scarce economic resources require a man to make difficult decisions in his life. The choice taken will necessitate giving up other possibilities, and this opportunity cost will be used to calculate production costs.

Function

Economic theory is concerned with the problem of scarcity. Consequently, determining the most effective use and distribution of this scarce resource is of mutual concern.

We must make decisions whenever there is a shortage. If we have 200 thousand rupiahs, we can use it to buy economics textbooks or eat out. As a result, many choices carry opportunity costs, and we must choose between the two that will benefit us in the long run.

Also read: Job Costing: Cost Calculation for Financial Management

Example

Humans have various choices when faced with various economic difficulties. Demands as a human being who fulfills all requests as much as possible. Every human being must have rational thinking to find various solutions to these challenges, thus enabling humans to maximize the potential of everything around them.

You can optimize the use of natural resources or other resources as a solution to economic difficulties. This explains the origin of the opportunity cost. Hence the scarcity of natural and economic resources may be a challenge for your business.

Circumstances require your business to take alternative actions. We can use available options to take alternative actions. We can overcome each obstacle by taking one action at a time. This can be overcome with Hash Manufacturing Automation because it can reduce the waste of purchasing raw materials easily and accurately.

In economics, when a business chooses one course of action over another, it loses the benefits of the other choice. In other words, the company will sacrifice for other possibilities as a result of its activities. This is the opportunity cost. The following is a more complete explanation:

War costs

If the government spends $870 billion on war supplies, it means that $870 billion they can’t spend on education, health care, or tax cuts/deficit reductions.

Expenditures for new roads.

If the government builds new roads, they cannot use the money for other alternative spending plans such as education and health care.

Tax rebate

When the government bids on income tax cuts, the opportunity cost is that government revenues can’t use to finance some aspects of government spending. HashMicro delivers EVA HRIS Essentials, providing solutions to every company problem you manage.

Time

If you have 12 hours for you to use throughout the day, then you can use these hours for work or leisure. The opportunity cost of spending all day watching TV so you can’t do anything else all day.

Enter the workforce at the age of 16.

If you enter the workforce at 16 without qualifications, you start earning money right away. But the opportunity cost is that you will lose the potential for better qualifications and possibly a higher salary in the long run.

Also read  : Fixed Costs and Variable Costs: Get to Know the Definition and the Examples!

How to Calculate Opportunity Cost

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Source: justworks.com

An investor determines the opportunity cost by comparing the returns of two alternatives. To achieve this can do so by forecasting future earnings during the decision-making process. Alternatively, this cost can be determined retrospectively by comparing returns over the period since the choice was made.

The following formula illustrates the calculation of opportunity cost, it is useful for investors in comparing the returns on different investments:

Opportunity Cost = Optional Investment Benefit – Lost Investment Benefit

Case example

When investors make decisions, they try to calculate prospective opportunity costs, but these calculations are much more accurate with hindsight. When you have actual data to deal with rather than just an estimate, then comparing the returns on the chosen investment to the lost options becomes much easier.

Also read: The Importance of Accounting Software for Businesses

For example, suppose you have to decide between buying stock in Company ABC and Company XYZ. He chose to buy ABC. A year later, ABC returned 5%, while XYZ returned 9%. In this case, he can measure the opportunity cost of 4% (9% – 5%).

Investor use opportunity often times to compare investments, but this concept is applicable to many different scenarios as well.

Opportunity Cost Limits

The main limitation of Opportunity Cost is the difficulty of accurately predicting future profits. You can study historical data to give you a better picture of investment performance, but you can never predict investment performance with 100% accuracy.

Opportunity cost considerations remain an important aspect of decision-making but are not accurate until a choice has been made and you can look back to compare how the two investments performed. While opportunity cost applies to all decisions, it becomes more difficult to calculate when non-quantifiable factors are involved.

Say you have two investment opportunities. One offers conservative returns but only requires you to tie up your cash for two years, while the other doesn’t let you touch your money for 10 years, but will pay higher interest with slightly more risk. In this case, part of the opportunity cost will include the liquidity difference.

Conclusion

That is a complete discussion of the opportunity cost. Opportunity cost is the potential gain lost by choosing a different investment or company path. When comparing two or more options, it refers to the worth of the options you must give up to pursue one. Regardless of which option is selected, there will be a fee assigned to the option that is ignored. 

In building a business, for example, you must continue to monitor every expense you incur for the progress of your business, including opportunity costs. Buying more complex equipment, hiring specialists to create new products, and more are all examples of opportunity costs.

HashMiro as one of the companies that provides the best Accounting Software also has asset management that will handle your assets so that they are of greater value and have longer economic value so that the opportunity costs for your business will be more profitable.

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Thamia Farisatuddiniyah
I hope readers get value and enjoy what I write.

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