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Every decision that you make is a fork in the road.
Regardless of what you choose, there will always be something you have to give up.
This analysis is commonly called opportunity cost.
Understanding opportunity costs can help you not only make smarter financial decisions but smarter decisions in all aspects of your life.
In this article, I’ll answer the question of what opportunity cost is and define commonly related terms.
I’ll provide a few examples, including simple social and financial situations, before explaining how you can use all this information to use opportunity cost analysis as decision-makers.
Table of Contents
What Is Opportunity Cost?
Opportunity Cost Defined (Plus Other Terms)
Opportunity cost is what you lose when you decide between two or more choices.
Every decision has some opportunity cost, including simple choices you make throughout the day.
Still, financial decision-making is where the term is mainly used.
Here is an example of how I was introduced to this concept.
I was in an economics class, and my professor asked us to pretend to be the business owner of an airline.
On one specific flight, you only had 100 of the 200 seats booked. Would you lower the price of the remaining seats to get them filled?
What is the consequence of doing this or not doing this?
This analysis is what opportunity cost is.
What do you give up by doing something else?
In this example, if you lower the price, you miss out on earning more revenue, but the money you make by filling these seats offsets some of your expenses.
If you don’t lower the price, you could get a full price if someone buys a ticket, but you have more expenses than revenue if they don’t.
Another example of opportunity cost is attending college.
By going to college, you give up earning a salary for four years.
- Read now: See how much $50 an hour is annually
- Read now: Here is your annual income if you earn $27 an hour
You choose to go to college because you believe you will earn more money during your career because of your college degree, which offsets the lost wages.
At its basic level, opportunity cost refers to what you stand to lose when choosing another option.
If what you gain is more beneficial than what you lose, it is a good decision.
It is essential to understand that opportunity costs can be explicit or implicit, meaning they’re outright calculated or implied losses of opportunity.
You can have both in the same decision, but understanding the difference can help leverage opportunity cost in your choices.
It’s also essential to understand the difference between opportunity cost and sunk cost and how opportunity cost relates to risk.
Explicit Costs And Implicit Costs
Opportunity cost takes two forms implicit costs and explicit costs.
Explicit costs refer to any direct, out-of-pocket costs you must deal with when deciding.
These are direct costs like:
- Purchase costs
- Renovation fees
- Covering bills
- Purchasing materials
An excellent example of an explicit cost is adding new items or services to your business.
This marginal cost will require your investment in labor, utilities, materials, and more, and the money could have been used elsewhere.
Implicit costs do not involve financial payment, but they indicate a lost opportunity to generate income through the resources you have.
For example, an implicit cost of foregoing employee training is the lost revenue from more knowledgeable employees.
There’s no specific way to determine how much this costs you, but you understand that you’re losing the opportunity to work potential deals as effectively.
This impact could cost you a client outright, but it may also lead to a less favorable agreement.
Opportunity Cost vs. Sunk Cost
Understand that opportunity cost is theoretical, a cost that has yet to happen.
Money that’s already spent and gone is called sunk costs.
While opportunity cost refers to the potential future returns you may not earn, sunk costs are the returns you did not earn.
While they aren’t the same, sunk costs have their place in the world of opportunity if they relate to the situation you’re considering.
For example, suppose you previously decided to purchase equipment your company did not use.
In that case, you’re unlikely to travel down that path if it presents itself in your future.
Sunk costs help you determine the best course for your investments.
- Read now: Learn how to become financially stable
Opportunity Cost And Risk
Your sunk cost helps you determine risk when weighing opportunity cost, but it’s important not to mix them up.
These are your decision-making tricycle’s three wheels to get where it’s going.
Risk refers to the possibility that a single opportunity’s real and projected returns are different.
Opportunity cost refers to the possibility that the returns of the investment you chose are lower than the investment opportunity you passed over.
The main difference is that risk compares the actual and projected performance of the same financial decision.
In contrast, opportunity cost compares the projected performance of different financial decisions.
It’s easiest to find the comparative advantage of decisions with the same risk level.
Discerning the right decision between a high-risk and low-risk decision extends beyond opportunity cost.
How To Calculate Opportunity Cost
To use opportunity cost, you must first learn how to calculate it.
The basic formula to follow is:
Opportunity Cost = Forgone Option Projected Returns – Chosen Option Projected Returns
This simple formula is easy to follow but can lead to better decision-making when paired with knowledge of how the trade-offs will affect the future of your financial decisions.
Opportunity Cost Is Not Conclusive
Opportunity cost is not the only factor to consider when making a financial decision, and plenty of other factors may weigh into your decision.
- Time frame
- Current income
While opportunity cost should play a part in your decision-making process, you aren’t making decisions in a vacuum.
Every opportunity has many factors to consider, manifesting in financial losses and returns and more implicit ripples down the line.
You get better at seeing the potential in your investments the more you deal with them.
Still, understanding that you can’t weigh investment options on numbers alone is essential when investing.
Examples Of Opportunity Cost
You make trade-off decisions based on opportunity costs in everyday life.
You set a path for the day when you decide what to wear or where to invest your time while getting ready.
You might shave some time off your routine by putting on the shirt you wore yesterday to get coffee on your day off, but it may cost you a bit of embarrassment when you realize there’s a stain on it.
A simple example of opportunity cost that’s easy to grasp is choosing between holding onto $10,000 cash versus putting it into a savings account with 1% APY for ten years.
- Read now: See how compound interest works
If you hold onto the cash, you’ll have the same $10,000 at the end of the tenth year, indicating no return.
If you put it into the savings, you’ll earn $1,051.25 at the end of the period.
Plugging this into the formula, assuming you choose to hold onto the cash, looks like:
Opportunity Cost = $1,051.24 – $0
You lose out on the opportunity of earning interest on the money.
This also doesn’t consider other factors, such as the protection offered by a financial institution or the effect of inflation.
- Read now: See how inflation impacts your wealth
Another simple example is going to the store and spending money on something.
What value will you add to your life if you buy the item?
If you don’t buy the item, what do you have?
You have the money spent on the item in your pocket, and you can use it to buy something else, or you could invest the money and have it grow into a larger amount.
Most opportunity cost situations are much more intricate than this, but they all start with this basic formula.
A more complicated example is whether to invest in the stock market or pay off debt.
Suppose you have high-interest debt, meaning it has an interest rate above 10%.
In that case, you are better off putting your money towards the debt since this is a guaranteed return on your money.
But if you have low-interest debt, things get more complicated.
While you would be better off investing the money, most people are better off paying down the debt.
The reason for this is that many people won’t put the money into an investment.
Instead, they will spend it.
They are in no better situation because they still have debt and don’t have anything saved.
So the next best alternative is to pay off the debt.
Weighing Opportunity Cost With Risk
You hear opportunity costs thrown around a lot regarding stock market investments.
Every investment choice you make has the potential for significant returns.
Still, you also risk losing the money you put in.
This makes weighing your options harder because you don’t know how the future will play out, which impacts your investment’s future value.
You can only use historical averages as resources to help you make the best choice.
Understand that every decision you make in life involves weighing the opportunity costs.
What do you gain in the future by making a particular decision, and what do you lose?
The more you can slow down and think through your decisions, the better you will start to make.
And while the payoff to making better decisions won’t show up immediately, in time, they will compound, and you will be amazed at the positive result.