When making a decision about how to spend your money, time, or use any other resource, there's inevitably going to be a tradeoff. You might be faced with the choice of buying a $10 sandwich vs. making it yourself, but making it yourself isn't free. Not only do you have to account for the cost of ingredients for making your own sandwich, but also the time and energy required. If you're in a rush, that $10 might be well worth it. This is where opportunity cost comes into play.

However, opportunity cost can also show up in terms of helping you realize that a decision costs more than you'd like. For example, the cost of that sandwich might not just mean spending $6 more buying it vs. making it. Instead, there could be an opportunity cost in terms of passing up on a healthier option if you bought the sandwich from a deli instead of making it at home. So, while saving $6 might not always motivate you to make your own lunch, the opportunity cost of nutrition might sway your decision.

Here, we'll take a look at what an opportunity cost is, how to find opportunity cost, and more.

Opportunity cost is a term that refers to the potential value that you forgo when choosing one option over another. It's an economic concept that can be applied to many different situations, from a business determining what projects to pursue, to an employee deciding to work overtime or spend that time with their family, to an investor choosing an index fund over a self-managed portfolio.

Opportunity costs can be easily overlooked because sometimes the benefits are unknown, theoretical, or hard to quantify.

There are essentially always limitations that show up in life and affect decision-making. You might have plenty of money to spend on a meal, for example, but only so much appetite. Every appetizer you order comes at the expense of enjoying the main course.

In other words, individuals inevitably face trade-offs when making decisions, and there is a cost associated with these decisions in terms of what we're giving up by choosing one thing over the other.

For example, if an investor decides to put $100 into ABC stock, that is $100 they cannot put into XYZ stock, or alternatively, some other kind of asset, such as a bond. That stock might gain 5%, but the opportunity cost could be that you're passing up on a bond that pays 6%.

Alternatively, if an individual spends $20,000 on a sedan instead of $30,000 on a minivan, that directly saves $10,000 but comes with the opportunity cost of having a smaller vehicle. Maybe you then run into issues like fitting everything in your car for family trips. So, there could be a cost in terms of inconvenience, but also sometimes that shows up in direct costs, such as if you end up spending money on rental vans.

Other examples appear in personal decision-making that aren't always directly about finances. If an individual chooses to get a master's degree to advance in their career, that will require many hours spent either in class or studying that cannot be used for other purposes, like traveling or relaxing with friends. That's not to say one is necessarily better than the other, but instead of just looking at the cost of tuition vs. the potential salary increases from an advanced degree, you might also consider the opportunity cost of spending your time in school rather than other areas of life that bring you enjoyment.

There are two main types of costs that factor into opportunity cost: explicit and implicit. These often are both present, but sometimes one is more dominant than the other.

"Explicit costs are those that are incurred when taking a specific course of action," says Bob Castaneda, program director for Walden University's MS in Finance program.

The explicit opportunity costs associated with a decision could include wages, materials, stock purchases, rent, utilities, and other tangible expenses. Any dollar amount required to move forward with a choice will fall under the explicit costs.

For example, if a business could spend $50,000 hiring an employee or $60,000 on new equipment, there's a $10,000 difference in explicit costs.

On the other hand, "implicit costs may or may not have been incurred by forgoing a specific action," says Castaneda.

Implicit costs are indirect and can be difficult to identify. They represent the income or other benefits that could possibly have been generated had you made the alternative choice.

Hiring an employee vs. spending money on new equipment might save $10,000 in explicit costs, but there could be implicit costs, like if that new equipment enables the business to manufacture more products to raise profit by $20,000.

So, the opportunity cost includes saving $10,000 in explicit costs and losing $20,000 in implicit costs, meaning that in this scenario, hiring the employee costs $10,000 more than buying the equipment.

Sometimes, however, these two aren't as linked. For example, choosing to watch one movie over another might have the same explicit costs, but the implicit cost is that you're missing out on the movie you didn't choose, which might mean lost enjoyment. This cost might never truly be known, especially since you can't recreate that exact moment, but in general, this exemplifies that choices aren't just about what you do; they're also about what you're not doing by choosing a particular option.

If you know the expected return of two choices, the opportunity cost formula is straightforward.

Here's a very simple way to put this formula into practice.

Let's say you are deciding to invest in either Company A or Company B. You choose to invest in company A, which provides an average return of 6% in one year. On the other hand, Company B has an average return of 10%.

The opportunity cost of choosing to invest in Company A versus Company B is 10% minus 6% in terms of average returns. With that choice, the opportunity cost is 4%, meaning you would forgo the opportunity to potentially earn an additional 4% per year on your funds. Yet this might be worth the cost to you if Company B is much riskier, such as due to the use of high leverage. The potential for an extra 4% might not be worth, say, the higher likelihood of losing all your money if Company B goes bankrupt.

However, you might not always know the returns or even be able to compare historical averages. For example, there's no exact formula for figuring out the opportunity cost of staying up late to finish a show. The opportunity cost is that you'll be tired the next day, so you need to weigh if that tiredness cost outweighs the benefits of watching the show.

Here are some more examples where opportunity cost shows up in different ways, not all of which have a clear formula:

Understanding the opportunity costs associated with your choices could illuminate the best path forward. Here are some different areas where opportunity costs show up:

Opportunity costs influence personal finance decision-making by presenting individuals with tradeoffs on individual purchases they make. For example, a person who spends $1,500 on rent every month cannot put those same funds toward a mortgage payment that might help them build equity over the long term.

Say a shoe manufacturer has the option of investing in new equipment that is expected to provide a return of roughly 9% in the first year. Alternatively, the company can put its money into low-risk securities that generate income of 3% a year.

If the organization opts to put its money into the income-producing securities instead of the new equipment, the opportunity cost will be 6% of the principal invested in the first year. Still, that might be worth it, or it might prompt the company to take the risk of investing in new equipment.

Opportunity cost can cause individuals to forgo everyday luxuries and even regular experiences. For example, a person could spend $12 watching a matinee movie, or they could use it to buy lunch. If they opt for the former, they may not have money for the latter, and vice versa. So, you might be saving money by catching a matinee, but you're still carrying the cost of not using that money for another activity.

Opportunity costs matter to investors because they are constantly selecting the best option among investments based on their goals and risk tolerance.

"Whenever an investor buys assets, they implicitly choose not to buy others," says Brian Jenkins, associate teaching professor of economics at the University of California, Irvine.

Jenkins expands with an example:

"From 2002 to 2021 the S&P 500 produced an average annual return of about 11%. Suppose that over that time, an investor managing her own portfolio was able to produce an annual return of 8%. By choosing to manage her own portfolio instead of holding a low-cost index fund that tracks the S&P 500, the investor gave up about 3% per year for 20 years — and probably took on more risk too — a substantial implicit opportunity cost."

As an investor, weighing the opportunity cost of each investment can help you make the most prudent decisions. Without this careful weighing of the options, you may find your portfolio filled with underperforming assets, whereas better options are readily available.

Another concept in cost accounting is sunk cost, which differs from opportunity cost.

"Sunk cost refers to the past costs that you have incurred," says Ahren A. Tiller, Esq., supervising attorney at Bankruptcy Law Center. "Let's say you've invested in Company X but gained nothing. The money you spent is a sunk cost, and it can't be recovered. You can't do anything about it, making it irrelevant in your decision-making."

In contrast, opportunity cost considers the loss of potential returns from an alternative investment decision.

For example, the money you've already spent on rent for your office space is a sunk cost. You can't change the past. But the funds you spend on office rent going forward would be an opportunity cost vs. an alternative like buying an office building.

Ultimately, Tiller says, "considering the opportunity cost will help show the most profitable option to invest in, making the decision-making process easier for you."