Opportunity cost is the profit lost when one alternative is selected over another. The concept is useful simply as a reminder to examine all reasonable alternatives before making a decision. For example, you have $1,000,000 and choose to invest it in a product line that will generate a return of 5%. If you could have spent the money on a different investment that would have generated a return of 7%, then the 2% difference between the two alternatives is the foregone opportunity cost of this decision.
Opportunity cost does not necessarily involve money. It can also refer to alternative uses of time. For example, do you spend 20 hours learning a new skill, or 20 hours reading a book?
Examples of Opportunity Cost:
The term is commonly applied to the decision to expend funds now, rather than investing the funds until a later date. Examples are:
- Go on vacation now, or save the money and invest it in a house.
- Go to college now, in hopes of generating a large return from the college degree several years in the future.
- Pay down debt now, or use the money to buy new assets that could be used to generate additional profits.
It is easy to incorrectly include or exclude costs in an opportunity cost analysis. For example, the opportunity cost of attending college does not include room and board, since you would still make this expenditure even if you were not attending college.