Content
Alternatively, if the business purchases a new machine, it will be able to increase its production of widgets. The machine setup and employee training will be intensive, and the new machine will not be up to maximum efficiency for the first couple of years. Let’s assume it would net the company an additional $500 in profits in the first year, after accounting for the additional expenses for training. The business will net $2,000 in year two and $5,000 in all future years. Funds used to make payments on loans, for example, cannot be invested in stocks or bonds, which offer the potential for investment income. The company must decide if the expansion made by the leveraging power of debt will generate greater profits than it could make through investments.
Thus, a sunk cost is backward looking, while an opportunity cost is forward looking. For example, a business pays $50,000 to acquire a piece of custom machinery; this is a sunk cost. Conversely, the opportunity cost represents an analysis of how the $50,000 might otherwise have been used. 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.
Example of Actual Opportunity Cost
As shown in the simplified example in the image, choosing to start a business would provide $10,000 in terms of accounting profits. A sunk cost is money already spent in the past, while opportunity cost is the potential returns not earned in the future on an investment because the capital was invested elsewhere. When considering opportunity cost, any sunk costs previously incurred are ignored unless there are specific variable outcomes related to those funds. Put it into economic terms, it is the risk of achieving greater benefits had you taken a different option.
You could have given that $30 to charity, spent it on clothes for yourself, or placed it in your retirement fund and let it earn interest for you. opportunity cost is the proverbial fork in the road, with dollar signs on each path—the key is, there is something to gain and lose in each direction. You make an informed decision by estimating the losses for each decision. The initial cost of bond “B” is higher than that of “A,” so you’d spend more hoping to gain more because a lower interest rate on more money can still create more gains. However, you’d have to make more than $10,000—the amount that came out of your pocket—to add value to bond “B.” Where P and Q are the price and respective quantity of any number, n, of items purchased and Budget is the amount of income one has to spend.
Opportunity Cost
Assume that, given $20,000 of available funds, a business must choose between investing funds in securities or using it to purchase new machinery. No matter which option the business chooses, the potential profit that it gives up by not investing in the other option is the opportunity cost. A firm tries to weigh the costs and benefits of issuing debt and stock, including both monetary and nonmonetary considerations, to arrive at an optimal balance that minimizes opportunity costs. Because opportunity cost is a forward-looking consideration, the actual rate of return (RoR) for both options is unknown today, making this evaluation tricky in practice. Understanding opportunity cost can help you make better decisions. When you fully understand the potential costs and benefits of each option you’re weighing, you can make a more informed decision and be better prepared for any consequences of your choice.
Second, the slope is defined as the change in the number of burgers (shown on the vertical axis) Charlie can buy for every incremental change in the number of tickets (shown on the horizontal axis) he buys. The slope of a budget constraint always shows the opportunity cost of the good that is on the horizontal axis. If Charlie has to give up lots of burgers to buy just one bus ticket, then the slope will be steeper, because the opportunity cost is greater.
