## The Formula

There is no specifically defined or agreed on mathematical formula to calculate opportunity cost, but there are ways to think about opportunity costs in a mathematical way.

Opportunity cost is the value of the next best alternative or option. This value may or may not be measured in money. Value can also be measured by other means like time or satisfaction.

One formula to calculate opportunity costs could be the ratio of what you are sacrificing to what you are gaining. If we think about opportunity costs like this, then the formula is very straight forward.

## What you sacrifice / What you gain = opportunity costs

Business also apply the concept of opportunity costs, but they tend to call it economic costs. For business, opportunity costs exist in the production process. Costs exist in general because scarce resources compete for different uses.

Opportunity costs in business relate to the foregone opportunities to produce alternative goods and services with these given limited resources. When businesses think about opportunity costs they see them this way:

Total revenue – economic profit = opportunity costs

Key to understanding how business sees opportunity costs is to understand the concept of economic profit. For business, economic profit is the amount of money made after deducting both explicit and implicit costs.

Explicit costs are the out-of-pocket expenses required to run the business. The idea of implicit costs is more abstract, but it takes into account value that could have been generated if the resources of the business had been used for other purposes.

This concept can be a bit complicated but the general idea is that a business needs to earn revenue in excess of its opportunity costs for the benefits to accrue to the owners of the business.

If a company is not able to earn an economic profit, the owners of the business will eventually exit the industry and the resources of the business will be put to a different use.

## How to calculate opportunity cost

For most people, it makes most sense to think about opportunity costs from the perspective of ‘what do I sacrifice?’ versus ‘what do I gain?’

For example, you may have the choice between two jobs, a mechanic or a bartender.

These figures are purely hypothetical and serve for the purpose of illustration of how to calculate opportunity costs. If you work as a mechanic, you could earn \$50 per hour. If you are a bartender, even with tips, your wage could be around \$25 per hour.

## So what are you giving up by working as a bartender versus working as a mechanic?

At first, it may look like \$25 per hour. But this is not the way opportunity costs are calculated. The formula is not “what I sacrifice minus what I gain.” Instead, it is necessary to look at the ratio of sacrifice to gain.

Going back to our example, if you chose to spend an hour working as a bartender instead of a mechanic, then you are actually giving up (\$50 mechanic / \$25 bartender) = \$2 of opportunity cost. This \$2 says, for every dollar, I earn working for one hour as a bartender, I sacrifice \$2 working the same hour as a mechanic.

It is important to look at the ratio between two alternatives to correctly calculate opportunity costs.