Opportunity Cost

Name: Opportunity Cost
Item: Opportunity Cost
Author: Doug Milnes, CFA

If You Don't Know What It Is, You Might Regret It

Updated: March 16, 2024

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What Is Opportunity Cost?

Have you ever faced an opportunity or choice and said to yourself, "If I don't do this, I'll regret it"? In a situation where you are deciding amongst several options, there's always a benefit you miss out on that's associated with the choice(s) you don't take. This foregone benefit can be thought of as a cost to you related to making your decision and, in the field of Economics, it's referred to as an opportunity cost. The simple definition of opportunity cost is:

Opportunity Cost is the benefit foregone related to the alternative choice when a decision is made.

In other words, an opportunity cost is the regret you anticipate from not taking another option. For example, if you spend your time studying for an exam, the opportunity cost would be the time you could have spent having fun.

This concept acknowledges not just the explicit costs of a choice but also the implicit costs of what you forgo when you make that decision. Opportunity cost provides a framework for decision-making to find the most benefit, particularly for limited resources like time and money.

Opportunity cost is the value or benefit of an alternative choice compared to the value of what is chosen.

The concept of opportunity cost is used in decision-making to help individuals and organizations make better choices, primarily by considering the alternatives.

Opportunity costs incorporate the cost and benefit of each choice, which can at times be challenging to estimate.

Opportunity costs are forward-looking. They don't consider previous costs incurred or benefits realized — only future costs and future benefits.

Opportunity Cost Example: Simple Investments

Within the context of investing, opportunity costs are the expected return on the investments you are evaluating. A simple example of opportunity cost in investing is in the bond markets. If you purchase bonds and hold them to maturity, they will provide a rate of return as stated. Pretend you have a bond that pays 5% and another that pays 2%, and you have $1,000 to invest. The expected return is $50 and $20, respectively. In this simple example, we can see that, all else equal, the bond paying $50 is the better choice. We can use this to illustrate how opportunity cost calculations are made.

Return on $1,000 Investment

The Formula for Opportunity Cost

Opportunity cost can be calculated as:

Where
FO is the return or value of the forgone option, and
CO is the return or value of the chosen option

The return on an option is signified as the benefit minus the explicit costs of that option. In the example above, the returns are $50 and $20. For a business, the return would be the profit it makes from selling its products.

Using this formula, when the opportunity cost is positive, it means there is an alternative option with a higher potential value than your current option. When the value of this equation is a negative number, there isn't a higher value option.

Opportunity Cost Calculation

The opportunity costs for these investments are as follows:

Investment Option	Opportunity Cost	Will You Regret It?
5% rate of return	($20-$50) = -$30	No - Opportunity Cost is negative.
2% rate of return	($50-$20) = $30	Yes - Opportunity cost is positive.

The -$30 and $30 are the opportunity costs of buying the other investment. That is, if you went with the 2% rate of return over the 5%, your "cost" or regret would be $30. In the instance where you select the 5% return investment, your "cost" is a negative $30, indicating you would not regret the decision.

Opportunity Cost Calculations: No Regrets With a Negative Number

This simple example helps us see how to calculate opportunity costs using the formula, but using opportunity costs has its challenges.

Opportunity Costs Can Be Hard to Determine

An illustrated woman balances two options in her hands: On the left, she is at work with colleagues, while on the right, she is at home with her family..

There are a couple of challenges to calculating opportunity costs. One challenge is that different people can value the same choices differently. In other words, they are subjective to individuals and situations. Another challenge is that in evaluating a decision, we may end up miscalculating the benefits.

MONEYGEEK EXPERT TIP

Opportunity costs for the same choices can differ for different people and in different situations.

Example: Valuing Leisure Time

Opportunity costs can be more difficult to assign numbers to when you're talking about an example like leisure time. Let's say your employer calls and offers you an extra hour of work at your job. You know the forgone benefit of saying no to your employer: it is the wages you won't earn. But what's the benefit of that time off? That might differ depending on what you do with your time, for example:

Running an important errand
Spending time with loved ones
Sleeping
Avoiding a long commute time

Thankfully, our brains are able to tell us what we value at the moment as it relates to our day-to-day lives.

Example: Opportunity Costs and Undervaluing Future Savings

In the last example, where you have an opportunity to earn an extra hour's worth of pay, we'll often neglect to consider the future value of our opportunities. If we work that extra hour and then invest those earnings in the future, it can grow to be worth much more.

There are many examples of the "skip the latte" argument in personal finance. Say you have a $5 latte every day instead of saving that $5. Over 20 years, you're not just missing out on the $36,500 you could have saved (365 days x $5 x 20 years). You're missing out on $61,655, which is the $36,500 you spent plus the investment returns you could have earned from compounding your savings for 20 years with a 5% annual investment return.

Opportunity Cost: Buying Daily Lattes vs. Investing the Savings

If you'd prefer to keep your latte, there are many ways to save, including reevaluating your budget, negotiating recurring expenses like insurance premiums, lowering interest rates and paying down debt.

MONEYGEEK EXPERT TIP

The power of compounding investment returns can make the prospect of forgoing expenses today more compelling.

Opportunity Costs, Sunk Costs and the Sunk Cost Fallacy

A woman sits at a desk, considering her options as she slowly sinks into quicksand.

Have you ever said or heard someone say, "I/we have already spent…" to justify why a choice is made?

Maybe you've heard a story of someone going to an outdoor concert to see an act they weren't that into in the pouring rain just because they had bought the ticket? Or a company continuing to spend money on a failing project because it had already spent a considerable amount on it? At some point, these people had a chance to reassess their situation and potentially back out, despite the costs they had already incurred. These already incurred costs are referred to as sunk costs, and they are costs you can't recover regardless of what you do.

Opportunity costs are strictly forward-looking and ignore costs you can't recover because they do not represent your benefit.

The Big Costly Project: A Sunk Cost Example

Say that a company has spent $5 million and two years implementing a new software system. They have one more year of work left and another $2.5 million to spend to complete the system. A new technology has come to the market that provides the same benefits. The new technology will take six months to implement and cost $2 million. In this example, the benefit is the same, so the opportunity costs are just the costs: one year for $2.5 million or six months for $2 million. The sunk cost is $5 million and the two years that had already been spent.

When the manager of the project starts to argue that the company has already invested $5 million in the technology, they are committing the sunk cost fallacy.

MONEYGEEK EXPERT TIP

The sunk cost fallacy is sticking to a course of action when other options have a higher return/benefit.

Opportunity Costs Should Adjust For Risk and Uncertainty

Because opportunity costs are forward-looking, to the extent that it's possible, they should include measures of uncertainty. If you're looking at a set of investment opportunities, your decision should factor in the uncertainty of gains or losses, your time horizon to recover and your subjective ability to stomach potential losses. For this reason, it's a best practice in the investment profession to match an individual's investment portfolio to their risk tolerance and time horizon.

Expert Insights

When asked to explain opportunity costs, what is your go-to example?
Can you provide a few examples of how individuals weigh opportunity costs every day?
What are the drawbacks or challenges to weighing the opportunity cost when making decisions?
Are there decision-making strategies individuals or organizations can use when the opportunity cost of a decision isn't clear-cut?
What's a good way for individuals to think about the opportunity costs associated with saving money or spending it today?

Steven Carnovale, Ph.D.Associate Professor of Supply Chain Management at Florida Atlantic University

Sung Ham, Ph.D.Associate Professor at Broad College of Business, Michigan State University

Kyle Dodrill, CFP®Investment Advisor at at Deschutes Investment Consulting LLC

Ryan LeeAssistant Professor of Economics at the University of La Verne

Sarah JacobsonProfessor of Economics at Williams College

Lawrence J. WhiteProfessor of Economics, Stern School of Business, New York University

Matt RutledgeAssociate Professor of the Practice of Economics at Boston College

Jared Watson, Ph.D.Assistant Professor of Marketing at New York University Stern School of Business

Nicolas JankuhnAssistant Professor of Marketing at the University of Southern Indiana

Dr. Brandon Di Paolo HarrisonAssistant Professor of Accounting at Austin Peay State University

Vicar ValenciaIndiana University South Bend

Dr. Michael SnipesAssociate Professor of Instruction at University of South Florida

John KorsakAssistant Teaching Professor, University of Massachusetts Lowell, Economics Department

Evan W. Osborne, Ph.D.Professor at Wright State University

David KuenzelAssociate Professor of Economics at Wesleyan University

Bruce SacerdoteRichard S. Braddock 1963 Professor in Economics at Dartmouth College

Jorgen HarrisAssistant Professor of Economics at Occidental College

Josh StillwagonAssociate Professor of Economics at Babson College

Matthews Barnett, CFP®, ChFC®, CLU®Financial Planning Specialist at Wiser Wealth Management, Inc.

Sahar BahmaniProfessor of Finance at the University of Wisconsin, Parkside

Aleksandar (Sasha) Tomic, Ph.D.Economist and Program Director of MS in Applied Economics Program, Associate Dean, Strategy, Innovation, & Technology, Woods College of Advancing Studies, Boston College

Leo Chan, Ph.D.Associate Professor of Finance at Utah Valley University

Wendy Habegger, Ph.D.Lecturer at James M. Hull College of Business at Augusta University

Brian JenkinsAssociate Teaching Professor and Director of Undergraduate Studies in the Department of Economics at the University of California, Irvine

Benjamin ShillerAssistant Professor of Economics at Brandeis University

Tonya Williams BradfordAssociate Professor at UCI Paul Merage School of Business, University of California

Linda M. HooksProfessor of Economics and Head of the Economics Department at Washington and Lee University

Danny ErvinProfessor of Economics and Finance at Salisbury University

Peter Zaleski, Ph.D.Professor of Economics at Villanova University

Derek Stimel, Ph.D.Associate Professor of Teaching Economics at the University of California, Davis

Scott DeacleAssociate Professor of Business and Economics and Department Chair at Ursinus College

Don Uy-BarretaProfessor of Economics

Samia Islam, Ph.D.Graduate Program Coordinator, Professor, Department of Economics at Boise State University

Zachary SchallerAssistant Professor of Economics at Colorado State University

Frequently Asked Questions

What is a simple definition of opportunity cost?

Opportunity cost is the difference in the benefit of a choice you are forgoing compared to the benefit of the choice you are making. You'll recognize opportunity cost as an estimation of how much regret you'll feel for making one choice over another.

Is opportunity cost a real cost?

Opportunity costs are real in the sense that there is always a missed opportunity when you're allocating resources (time, money, etc.). Economists may refer to opportunity costs as the real costs. However, it's important to note that opportunity costs will not be reflected in a bank account or a company's income statement because they only reflect the choices made, not the choices that are not taken.

What is an example of opportunity cost?

A simple opportunity cost example is choosing between two investment options with a guaranteed return. Suppose they both require the same amount of investment, but one will pay you $50, and the other will pay you $20. The opportunity cost is -$30 for the $50 return, indicating there isn't a cost but rather a net benefit. The opportunity cost for the $20 return is $30, indicating that choosing the $20 return option would mean you're missing out on a higher potential benefit.

This is simple when the net benefit or return is known. But determining the net returns of options isn't always clear-cut. For example, how do you choose between an extra hour of leisure time or an extra hour of paid work?

Why is opportunity cost important?

Opportunity cost is a framework that helps us understand choices and can be used to help select the best choice in how to use a scarce resource (time, money, etc.). It's a powerful concept that is the basis for several other economics and behavioral economics concepts, such as comparative advantage. In business and investing contexts, opportunity costs are analyzed in a variety of decisions, such as which products to create and portfolio allocation.

Can the opportunity cost be zero?

Yes. The formula for calculating opportunity cost is to compare the net benefit of one choice with the benefit of another option. If the difference between those benefits is zero, then the opportunity cost is zero, meaning you'd get the same benefit from either choice.

About Doug Milnes, CFA

Doug Milnes is a CFA charter holder with over 10 years of experience in corporate finance and the Head of Credit Cards at MoneyGeek. Formerly, he performed valuations for Duff and Phelps and financial planning and analysis for various companies. His analysis has been cited by U.S. News and World Report, The Hill, the Los Angeles Times, The New York Times and many other outlets.

Milnes holds a master’s degree in data science from Northwestern University. He geeks out on helping people feel on top of their credit card use, from managing debt to optimizing rewards.

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Opportunity Cost

What Is Opportunity Cost?

Opportunity Cost Overview

Opportunity Cost Example: Simple Investments

Return on $1,000 Investment

The Formula for Opportunity Cost

Opportunity Cost Calculation

Opportunity Cost Calculations: No Regrets With a Negative Number

Opportunity Costs Can Be Hard to Determine

Example: Valuing Leisure Time

Example: Opportunity Costs and Undervaluing Future Savings

Opportunity Cost: Buying Daily Lattes vs. Investing the Savings

Opportunity Costs, Sunk Costs and the Sunk Cost Fallacy

The Big Costly Project: A Sunk Cost Example

Opportunity Costs Should Adjust For Risk and Uncertainty

Expert Insights

Frequently Asked Questions

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