Why opportunity cost is important

There are many examples of the "skip the latte" argument in personal finance. If you'd prefer to keep your latte, there are many ways to save , including reevaluating your budget, negotiating recurring expenses like insurance premiums , lowering interest rates and paying down debt. The power of compounding investment returns can make the prospect of forgoing expenses today more compelling.

Maybe you've heard a story of someone going to an outdoor concert to see an act they weren't that into in the pouring rain just because they had bought the ticket?

Or a company continuing to spend money on a failing project because it had already spent a considerable amount on it? At some point, these people had a chance to reassess their situation and potentially back out, despite the costs they had already incurred. These already incurred costs are referred to as sunk costs, and they are costs you can't recover regardless of what you do. Opportunity costs are strictly forward-looking and ignore costs you can't recover because they do not represent your benefit.

A new technology has come to the market that provides the same benefits. Because opportunity costs are forward-looking, to the extent that it's possible, they should include measures of uncertainty. If you're looking at a set of investment opportunities, your decision should factor in the uncertainty of gains or losses, your time horizon to recover and your subjective ability to stomach potential losses.

For this reason, it's a best practice in the investment profession to match an individual's investment portfolio to their risk tolerance and time horizon.

Lecturer at James M. Hull College of Business at Augusta University. Opportunity cost is the difference in the benefit of a choice you are forgoing compared to the benefit of the choice you are making.

You'll recognize opportunity cost as an estimation of how much regret you'll feel for making one choice over another. Opportunity costs are real in the sense that there is always a missed opportunity when you're allocating resources time, money, etc.

Economists may refer to opportunity costs as the real costs. However, it's important to note that opportunity costs will not be reflected in a bank account or a company's income statement because they only reflect the choices made, not the choices that are not taken. A simple opportunity cost example is choosing between two investment options with a guaranteed return.

This is simple when the net benefit or return is known. If he or she farms the land, the opportunity cost is the income foregone by not renting it to a neighbor. This example can be taken a step further. The land could be sold and the proceeds invested elsewhere.

If you are contributing your labor to a value-added business, the opportunity cost is the income foregone by not employing the labor elsewhere. Further, the available options should have an economic value. The foregone option may be a product or a service. These options can be anything- from taking production decisions to investment decisions. Also, they can be making a purchase decision to even valuing time spent on a particular activity.

Explicit costs are the costs that a person or an entity incurs to avail of the benefit of an activity or service or product. It means that the producer has lost an opportunity to spend this amount to buy some other product or service. On the other hand, implicit opportunity costs are the costs that are notional or implied in nature. They are the costs of not choosing an available option. For example, the inherent opportunity cost of setting up a production unit is the loss of opportunity of investing the same amount of money in real estate and selling it after that.

The concept of Opportunity Cost is crucial in the world of business and finance. It explains the rationale of the economic decisions taken or chosen with regards to the other available options. Inferred consent can occur:. Identification Any commercial electronic message sent by Fifo Capital will include a clear and accurate identification information about Fifo Capital, the sender of the message and how we can be contacted.

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