Opportunity Cost: Formula & Analysis

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  • 0:04 Opportunity Cost
  • 1:09 Formula for Opportunity Cost
  • 1:54 Example of Formula for…
  • 2:36 Capital Structure Decisions
  • 5:04 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley
A fundamental economic analysis - whether you're running a country, a business or your personal finances - determines the opportunity costs of a decision. In this lesson, you'll learn about opportunity cost, its formula and how to calculate it.

Opportunity Costs

Meet Lilith. She owns a small, start-up tech company that manufactures smartphones and tablets. Lilith has some important business decisions to make concerning the allocation of her company's resources over the next fiscal year. A large part of her decision-making analysis will concern calculating and assessing opportunity cost.

You can think of opportunity cost as the benefit or value you give up by picking one course of action over another. In other words, the opportunity cost of a decision is the difference between the value you receive from pursuing a course action and the value that you would have received from the alternative you did not pursue. Let's look at Lilith's tech company to illustrate the concept.

Lilith can use one day to manufacture either 100 smartphones or 75 tablets. If she chooses to manufacture the phones, the opportunity cost is the difference in profits of producing 75 tablets. On the other hand, if she chooses to manufacture the 75 tablets, it costs her the difference in profits of manufacturing 100 smartphones.

Formula for Opportunity Cost

We generally want to analyze opportunity costs in terms of investment, whether it's a person or a business making that investment. We can express opportunity cost in terms of a return (or profit) on investment by using the following mathematical formula:

  • Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue

Unless the investment returns are fixed and practically guaranteed to be paid (like a U.S. Treasury bond you intend to hold to maturity), you'll have to base your calculation on the expected returns. For example, on average, the stock market may have an annual return of 8%, but that doesn't mean your stock portfolio will return 8% this year.

Now, let's apply the formula to an example. Lilith's company has a 10% return when it sells smartphones, but an 18% return when it sells tablets. Let's plug in the numbers and see what happens:

  • Opportunity Cost = Return on Most Profitable Investment Choice - Return on Investment Chosen to Pursue
  • Opportunity Cost = 18% (return on tablets) - 10% (return on cell phones)
  • Opportunity Cost = 8%

If Lilith orders the production of smartphones, she'll have to give up the opportunity to earn an extra 8%. Of course, we are assuming that there is sufficient demand for tablets to expend all Lilith's production capacity on tablets.

Capital Structure Decisions

You can use an opportunity cost analysis to help you decide how to best capitalize a business. A business' capital structure is simply how a company finances its operations. Capital structure may involve a mix of long-term debt, short-term debt, and equity. Equity is the infusion of capital into a business through the sale of shares of common stock or preferred stock to investors.

What does opportunity cost have to do with a business's capital structure? If you finance your capital through debt, you have to pay it back even if you aren't making any money. Moreover, money allocated to servicing debt can't be spent on investing in the business or pursuing other investment opportunities, such as the stock and bond markets. Let's look at an example on how a business can use opportunity cost analysis to determine whether or not obtaining an infusion of capital through debt is a smart move.

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