Is the benefit that is missed or given up when an investor individual or business chooses one alternative over another?

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• Opportunity cost represents the benefits forgone by choosing one option over another.
• Recognizing opportunity costs can help you make better decisions in all aspects of your life.
• It can be difficult to identify opportunity costs when the benefits of the alternative choice aren't easily quantifiable.
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Opportunity cost is a term that refers to the potential reward that you forgo when choosing one option over the next-best alternative. It's a microeconomic concept that can be applied to many different situations, from a business determining what projects to pursue, to an employee deciding to work overtime or spend that time with their family, or an investor choosing an index fund over a self-managed portolio.

Opportunity costs can be easily overlooked because sometimes the benefits are unrealized, and therefore, hidden from view. 

When looking at opportunity costs, economists consider two types: explicit and implicit.

Explicit opportunity cost

"Explicit costs are those that are incurred when taking a specific course of action," says Dr. Bob Castaneda, program director of Walden University's College of Management of Technology. 

The explicit opportunity costs associated with a decision could include wages, materials, stock purchases, rent, utilities, and other tangible expenses. Any dollar amount required to move forward with a choice will fall under the explicit costs. 

Implicit opportunity cost

On the other hand, "implicit costs may or may not have been incurred by forgoing a specific action," says Castaneda.

Implicit costs are indirect and can be difficult to identify. They represent the income or other benefits that could possibly have been generated had you made the alternative choice. 

How to calculate opportunity cost

The formula to calculate opportunity cost is straightforward. 

Here's how it works:

Here's a very simple way to put this formula into practice. 

Let's say you are deciding to invest in either Company A or Company B. You choose to invest in company A, which provides a return of 6% in one year. On the other hand, Company Z had a return of 10% in the same year.

The opportunity cost of choosing to invest in Company A versus Company B is 10% minus 6%. With that choice, the opportunity cost is 4%, meaning you would forgo the opportunity to earn an additional 4% on your funds. 

Opportunity cost examples

Every decision has trade-offs involved, not just investing. So, how does opportunity cost play out in the real world? Here are some examples to consider:

• A business owner wants to add a new product to the lineup. It requires an upfront investment of $1,000 to build and market. The opportunity cost is the potential value of that money being spent elsewhere or saved for the future. 
• A worker with a full-time job earning $50,000 per year decides to return to school to complete a master's degree that will enable her to increase her salary. The opportunity cost of this choice is the income she won't earn while focusing her time and energy on school in the meantime. 
• A booklover spends $150 per month feeding her habit. If she switched from buying books to borrowing them from the library, and earned 4% interest on the money she saved, she would have $9,926.85 at the end of five years. Those savings would be the opportunity cost of continuing to buy books.

Now, take a minute to consider the decisions on the horizon in your life. Understanding the opportunity costs associated with your choices could illuminate the best path forward.

Opportunity cost vs sunk costs

Another concept in cost accounting is sunk costs.

"Sunk cost refers to the past costs that you have incurred," says Ahren A Tiller, Esq., Bankruptcy Law Specialist. "Let's say you've invested in company X but gained nothing. The money you spent is a sunk cost, and it can't be recovered. You can't do anything about it, making it irrelevant in your decision-making."

In contrast, opportunity cost considers the loss of potential returns from an alternative investment decision.

For example, the money you've already spent on rent for your office space is a sunk cost. But the funds you haven't spent on office furniture yet would be considered an opportunity cost because you haven't actually spent the money yet. 

Ultimately, Tiller says, "considering the opportunity cost will help show the most profitable option to invest in, making the decision-making process easier for you."

Sarah Sharkey is a personal finance writer who enjoys helping people make better financial decisions. Sarah enjoys traveling, hiking and reading when she is not writing. You can connect with her on her blog Adventurous Adulting.

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