Definition & Meaning
When economists refer to the “opportunity cost” of a resource, they mean the value of the next-highest-valued alternative use of that resource. It is the process of choosing one good or service over another. The item that you don't pick is the opportunity cost. It has to do with what it costs a company to produce goods or services in terms of what could have been earned by using those same resources to produce different goods or services. Essentially, opportunity cost is all about comparing one production option to another production option. This involves determining the value received from one going with the production of one option versus what could be earned by choosing to go with a different option, using the same raw materials.
For example, corn is a common food commodity. The corn may be processed and sold in cans, or prepared with a slightly different process and sold in frozen packages. Alternatively, the corn could be ground into meal and packaged in sealed bags. The seller would want to investigate the relative merits of producing each product type from the same commodity, and compare the cost involved with choosing one line of production, or opportunity, over the other two.
Types of Opportunity cost
1) PERSONAL OPPORTUNITY COSTS
An important personal opportunity cost involves time that when used for one activity cannot be used for other activities. Time used for studying, working, or shopping will not be available for other uses. The allocation of time should be viewed like any decision: Select your use of time to meet your needs, achieve your goals, and satisfy personal values.
Other personal opportunity costs relate to health. Poor eating habits, lack of sleep, or avoiding exercise can result in illness, time away from school or work, increased health care costs, and reduced financial security. Like financial resources, your personal resources (time, energy, health, abilities, and knowledge) require careful management.
2) FINANCIAL OPPORTUNITY COSTS
You are constantly making choices among various financial decisions. In making those choices, you must consider the time value of money, the increases in an amount of money as a result of interest earned. Saving or investing a dollar instead of spending it today results in a future amount greater than a dollar. Every time you spend, save, invest, or borrow money, you should consider the time value of that money as an opportunity cost. Spending money from your savings account means lost interest earnings; however, what you buy with that money may have a higher priority than those earnings. Borrowing to make a purchase involves the opportunity cost of paying interest on the loan, but your current needs may make this trade-off worthwhile.
The opportunity cost of the time value of money is also present in these financial decisions:
- Setting aside funds in a savings plan with little or no risk has the opportunity cost of potentially higher returns from an investment with greater risk.
- Having extra money withheld from your paycheck in order to receive a tax refund has the opportunity cost of the lost interest the money could earn in a savings account.
- Making annual deposits in a retirement account can help you avoid the opportunity cost of having inadequate funds later in life.
- Purchasing a new automobile or home appliance has the potential benefit of saving you money on future maintenance and energy costs.
Tools to find Opportunity cost
1) Simple interest calculations
Three amounts are required to calculate the time value of money for savings in the form of interest earned:
- The amount of the savings (commonly called the principal).
- The annual interest rate.
- The length of time the money is on deposit.
These three items are multiplied to obtain the amount of interest. Simple interest is calculated as follows:
For example, $500 on deposit at 6 percent for six months would earn $15 ($500 × 0.06 × 6/12, or 1/2 year).
You can calculate the increased value of your money from interest earned in two ways: You can calculate the total amount that will be available later (future value), or you can determine the current value of an amount desired in the future (present value).
2) Future value of single amount
Deposited money earns interest that will increase over time. Future value is the amount to which current savings will increase based on a certain interest rate and a certain time period. For example, $100 deposited in a 6 percent account for one year will grow to $106. This amount is computed as follows:
The same process could be continued for a second, third, and fourth year, but the computations would be time consuming. Future value tables simplify the process To use a future value table, multiply the amount deposited by the factor for the desired interest rate and time period. For example, $650 at 8 percent for 10 years would have a future value of $1,403.35 ($650 × 2.159). The future value of an amount will always be greater than the original amount.
(Source : Jack .R Kapoor)