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Opportunity Cost Examples

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Graduation Versus Salary
Stocks Versus Cash
Vacation Versus training
Paying off debt Versus Spending on Welfare by the government
Entrepreneurship versus steady job
Selling Stocks now and 2 months later
Investing in stocks or higher degree

Let us understand these examples in detail:

Example #1 - Graduation Versus Salary

A person named X is currently working in a company and drawing some salary. X is getting an option to do the graduation for 2 years, but for that, he/she must leave his/her job. If he/she doesn’t go to graduation, the opportunity cost will be a higher degree plus the additional salary that he/she might get because of this degree. On the other hand, if he/she opts for the job, then the opportunity cost will be 2 years’ salary that has to be foregone.

Example #2 - Stock Versus Cash

Let’s say you got $50,000 in your bank account, which you don’t need right away. You can have many options with this cash. For example, you can just keep this cash, or you can invest this money in stocks. Let’s say if you would have invested wisely that money in some good stocks, and after a year, 50,000 would become $60,000. On the other hand, if you keep this money idle instead of investing in cash, then your opportunity cost will be the difference between 60000 and 50000, i.e., $10,000

Example #3 - Vacation Versus Training

Your school has announced a vacation. You finally get a chance to go for the holidays for the next 1 month. But suddenly you came to know that training is scheduled for your favorite sports which you do not want to miss. So, if you go on vacation, then your opportunity cost will be missing the training session, and if you stay for training, then your opportunity cost will be enjoying the vacation.

Example #4 - Paying off Debt Versus Spending on Welfare by Government

A country’s government is preparing its budget. It is having some surplus which can be used for paying off its debtor can be used for introducing some welfare schemes for its citizens such as subsidy. If it pays off its debt instead of a welfare scheme, then that would be classified as an opportunity cost for its citizens.

Example #5 - Entrepreneurship Versus Steady Job

You are having a steady job with a good income, but your passion is to open your own business, which required you to leave your current job, and you have to spend a lot of money on opening business initially. You have both options. If you are choosing a steady job instead of opening a new business, then your opportunity cost will be not having work you wanted and maybe success because of the new business. If you start your business, the opportunity cost would be a steady job and a paycheck from it.

Example #6 - Selling Stocks Now and 2 Months Later

You are having shares of a company worth $5,000. You are thinking of selling that shares now or wait for 2 more months. Let’s say, after 2 months, shares would be worth $6,000. If you sell the shares now, then your opportunity cost would be 6000-5000= $1,000, which you could have got if you would have waited for 2 more months.

Example #7 - Investing in Stocks or Higher Degree

You have got $20,000 in which you are thinking of either investing in shares of some company, or you can invest this money in getting a higher degree in a good university. If you invest in stocks, then your opportunity cost would be higher degrees and a higher salary because of the degree. But if you invest in a higher degree, then your opportunity cost would be profit gained from those shares.

Opportunity Cost Formula Explained in Video

Opportunity Cost Practical Example (IBM Acquiring Red Hat)

In Oct 2018, IBM announced that it is going to acquire Red Hat for a total deal value of $34 Bn. Red Hat is an open-source software company that is mainly in the cloud market. IBM is trying to strengthen its cloud business for a long, and this acquisition could prove a crucial point in its strategy. Red Hat shareholders will receive $190 per Red Hat shares with this deal. Now below is IBM’s balance sheet as per the 2018 annual report:

Source: www.ibm.com

As we can see that in their books, they are having Cash and Equivalents of around $11.4 Bn. They are also issuing debt for paying for this deal. Instead, they could use this money for paying a dividend to its shareholders or opening a new R&D center. So, the opportunity cost for IBM shareholders will be this dividend or profit from some new R&D center if IBM had not done this deal.

Conclusion

Opportunity Cost is a very important concept if an individual/company wants to think rationally between the options. With this strategy, a firm can think that what it is foregoing with choosing the option. Companies use this concept for any capital or investing decision while calculating “Cost of Capital.” By the above-mentioned examples, you can understand what it means and how it can be applied in different scenarios to choose between the option.