Opportunity Cost: What It Is and How to Account for It

The way to calculate the opportunity cost is to subtract the value of the option from the value of the alternative that is foregone.

Opportunity Cost = Return on the best foregone alternative - Return on the chosen option.

Opportunity cost calculation is essential to individuals, corporations and governments, where there are decisions to be made regarding limited resources like time, money and effort. Choosing one of the scarce resources always leads to a trade-off in gains.

It is important to account for risks associated with the different available options. Often the rewards that different options offer come with a certain risk.

Many people and organizations fail to take into account the various opportunity costs.

• We need to actively question ourselves about the alternatives that may be missed out by deciding on a particular option.
• The often neglected cost of waiting too long is also a decision that can incur a significant amount of opportunity cost, as we lose the time window to take action, losing the better option due to delay and inaction.
• Not taking an action is also a decision that needs to be evaluated, just like other options.

Certain external constraints make us overestimate the opportunity cost, as we start to imagine all the foregone options as a missed opportunity and start to see the situation irrationally. This can cause a negative emotional and psychological reaction, like regret.

The opportunity cost in these cases should not be viewed as the sum of all your skipped alternatives, but only the value of the best one which is foregone.