What is Opportunity Cost?Opportunity cost is a differential cost that occurs by using less effective resources. In planning and analyzing opportunities it is an important concept to consider. When you have certain resources at your disposal, and you choose to use the less effective one, you incurred opportunity cost. Why do you need to know this? Because when you ignore this analysis, it costs you dearly. Here is an example The boss needed to add one extra office next to an existing office. The build-out plus furniture costs were $8,000. There was a possibility of doing this for $6,500, but his decision was to build the office according to the more expensive company standards. Opportunity cost = $1,500. Another example: You invest money in a financial instrument which pays 2.5%. Another financial instrument is paying 1.75%. All things being equal (same bank, same length of time, same deposit), your opportunity cost is 0.75% if you invest in the lower paying instrument. When you plan, your challenge is to use your resources in the most effective and efficient way. If the most favorable alternative is not chosen (like in the examples above), you have incurred an opportunity cost. How do you calculate the opportunity cost? It's simple: 1. Identify all the possible alternatives available. 2. Calculate the risk and rate of return for each alternative. 3. Make a choice after comparing and taking other factors into consideration. Also, get a little help from making decision page. Sometimes there are valid reasons for doing the more expensive choice. For example, adhering to standards like in the furniture standard above, or lowering investment risks.
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