Getting error while adding formula field as "Formula fields should be configured in the field menu dropdown"

That’s not the error message, those are just instructions. The error message is simply the word #ERROR.

The problem is that Airtable can’t encode a lookup field, because a lookup field is an array instead of a text string.

In your formula, you can force-convert the lookup field into a text string by adding
& ""
after the name of the lookup field (after the closing curly bracket that surrounds the field name).