When weighing investment decisions, investors often use the concept of opportunity cost to help them decide on which option is more profitable. This concept is applicable to many different scenarios and is especially helpful when resources are limited. In the world of business, the opportunity cost of higher education can be more important than the annual wage of an employee, for example. Essentially, the opportunity cost of pursuing a college degree means paying for a year’s wages in addition to a year’s worth of benefits.
Consider a scenario in which a private investor decides to invest $10,000 in a security. After a year, the price of the security appreciated from $10 to $10,500. This means that the opportunity cost of the investment is 5 percent. However, the investor considers other investments. He might consider buying a government bond, for example, which would earn six percent a year. If this investment yielded 7.5 percent, it would have appreciated to $10,600 by the end of the year.
The term opportunity cost is derived from the concept of a decision that alters our personal landscape. An opportunity cost may be financial, professional, family, or lifestyle elements. As a business owner, you must weigh the implications of any decision, including the opportunity cost, before making the final decision. As a result, the opportunity cost is a tangible figure that can impact your decisions. A business owner should carefully consider the opportunity costs of a potential investment.
For instance, a private investor could choose to invest $10,000 in bond “A” rather than $10,500 in bond “B”. The investment would then increase in value by 5 percent. If the private investor chooses to invest the same money in a government bond or a bank certificate, the opportunity cost would be six percent. Consequently, after a year, the value of the investment would be $10,750 instead of $10,500.
As an example, the opportunity cost of a $4.49 cappuccino habit dwarfs that of a $4,000 getaway trip. By considering the opportunity cost, consumers are encouraged to avoid putting themselves in autopilot mode when it comes to evaluating their finances. They should instead consider the benefits and costs of other options, as well as their own unique situation. A company should not waste its time and resources on opportunities that are not valuable to it.
In this example, the company has already spent $5 million and two years developing a new software system. However, there is a new technology that provides the same benefits at half the price. Considering the opportunity cost of the new technology, the company will save approximately $2 million in the long run. While this is a great opportunity, it is important to remember that the opportunities that were lost are not sunk costs. The money was not saved.