Introduction to Opportunity Costs Examples
The following Opportunity Cost examples outline the most common Opportunity Costs examples:
- Through this example let’s explain how opportunity cost impacts the Economic profits and the inclusion of Implicit Opportunity Costs helps in determining the true economic profit for the business.
Examples of Opportunity Cost
Below is the list of examples of Opportunity Costs:
Example 1 – Accounting Profit and Economic Profit
The following information pertains to the recent financial year for Insulin International Limited.
Apart from the above expenses Mr. Smith, the Proprietor of Insulin International Limited invested in the business-owned funds amounting to $80000 per year and also took a pay reduction of $30000.
Based on the above facts we can observe that:
Accounting Profit = Revenues – Expenses
= $350000 – ($100000+$25000+$30000+$5000)
= $190000
However, after adjusting for Opportunity costs, Economic Profit will be different which is shown below:
Economic Profit = Accounting Profit – Implicit Opportunity Costs
= $190000-($80000+$30000)
= $80000
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Example 2 – Capital Budgeting Decisions
Frank International is making capital budgeting decisions. The company has a total capital budget of $100000 and requires a minimum IRR of 12%. Finance Managers at the firm brought two projects for investment namely;
Due to limited funds, Frank International has to make a choice between the two projects. Frank International chooses Project A over Project B, although both projects return in excess of its threshold IRR of 12%. Thus declining Project B is the opportunity cost of Project A.
Example 3 – Real Life Opportunity Cost Example
Another example from our day to day life relating to Opportunity Cost relates to the choice of one option over another. In that case, the cost of choice foregone is Opportunity Cost. Let’s understand with an example:
Mr. Andrews provides consultancy on Legal matters and charges an hourly rate of $500 from clients. He is looking for somebody to do typing work for his book which normally costs a monthly charge of $1000. If he decides to do it himself it will take him 3 hours to do so. By choosing to do on its own, Mr. Andrews opportunity cost is the number of consultancy charges foregone by him which is equivalent to $1500.
Example 4 – Study Related Opportunity Cost Example
Celeste is currently working in the Audit Division of a large Big 4 firm and drawing an Annual Pay of $50000. She plans to pursue her MBA from Wharton which will cost her $100000 and she will have to stay without work for 2 years as it’s a full-time course. The Opportunity cost for Celeste is losing the Annual pay of $50000 each for 2 years in order to pursue her MBA from Wharton.
Example 5 – Tradeoff
Opportunity cost examples can also be looked from the point of view of a tradeoff as well between the choices foregone for the choice availed. Let’s explain the same with the help of an example:
Costa Rica a developing nation holds a National debt of $3000 billion and requires paying an interest bill on the national debt that amounts to$340 billion annually. By making such a payment the Costa Rica government makes a tradeoff of spending less money on welfare programs on the economy on Infrastructure Development, Healthcare, and Education, etc. Thus the opportunity cost of making Interest payment is the amount foregone on social welfare schemes by the Costa Rica Government.
Example 6 – Derivatives Trading
Let’s undertake one example related to Derivatives Trading and the role and impact of Opportunity Cost in the same.
ABC Bank is holding a large position in NASDAQ listed Chegg Company. The stock is currently trading at $35 per share. The Bank intends to cover its exposure in the company without selling the stock and intends to adopt a strategy that can result in Income generation as well.
In order to achieve the intended objective ABC Bank sells near-money calls of $40 for near expiry month which resulted in income generation for ABC Bank in the form of the premium received on selling such call options. The strategy adopted by the Bank on shares of Chegg is called a Covered Call Strategy and it led to the generation of income for the Bank. However, the Opportunity Cost of such a covered call is giving up the upside on the long stock position of Chegg Inc when the stock price rises beyond the exercise price of the short call $40. Thus by giving up the opportunity cost of the upside of Chegg Inc beyond $40, ABC Bank succeeded in generating Income.
Example 7 – Bank related Decision
Another example relates to the decision of a Bank related to accepting or rejecting Credit Applicants. Let’s understand the same
Rancoft Bank in Chicago is evaluating whether to set its cutoff FICO score of 680 to approve or reject credit facilities to the pool of applicants. The Bank in the past has advanced credit facilities with a cutoff score of 660 and observed 20% accounting turning bad at a later date.
As per Bank estimates by increasing the cut-off score to 680, it estimates losing a good pool of applicants with an estimated business loss of $250000 while a reduction in its Bad Account from earlier 20% to 5%. Thus, if Rancoft Bank decides to increase its cutoff FICO score from 660 to 680 it will succeed in reducing its Bad Accounts count to 5% from the erstwhile 20%, however, the Opportunity Cost of such a decision is the business loss of $250000.
Conclusion – Opportunity Costs Examples
We can observe in our day to day life each decision we undertake has an Opportunity Cost attached to it. By opting to study in our early years of life, the opportunity cost we are giving up is the recreation and leisure time with family and friends. Similarly, a working woman professional giving up her job after marriage to take care of her new family has an opportunity cost of Income which she would have earned while working and so on. There are unlimited examples of Opportunity Cost which we encounter every day in day out in our work and normal life.
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