Opportunity cost is the loss incurred, or a potential benefit given up when making one choice instead of another. This article will teach you how to calculate opportunity cost for the decisions you make.
Ice cream lovers, I have a question for you. I give you an option to choose between two flavors of ice-cream – strawberry or chocolate. Which one would you pick?
If one of them is your favorite, you decide in an instant. If you hate one of the flavors, you make a decision quickly. Even if you love both these flavors equally, you hardly have anything to lose by making a choice. Your only loss is the pleasure of tasting the other flavor. So that was a simple question that required a simple decision.
Now, let’s consider another scenario where the decision isn’t as straightforward. Try to recall a situation from your life where you had to make a difficult choice. For example, picking a college to enroll yourself in, choosing your specialization or deciding between two job offers you had.
Did you decide as quickly as you did while choosing a flavor of ice cream? Heck no. You had trouble zeroing down on one choice, didn’t you? And the reason behind the dilemma was, no matter which option you chose, you’d something to lose for not picking the other choice. For example:
- If you chose mechanical engineering for the love of machines, you’d lose out on the bigger job market for computer science
- If you chose to work at an MNC for marginally higher pay, you’d lose the chance to learn faster at a startup.
But, at the end of the day, you have to make such decisions. So, you choose the option most beneficial to you and forgo the advantages of the other choices you had. What you lose by making a decision is called opportunity cost.
- What is opportunity cost in economics?
- How to calculate opportunity cost?
- The formula for opportunity cost
- Real-life examples of opportunity cost
- How to account for opportunity cost in your decisions
What is opportunity cost in economics?
Opportunity is the potential gain an individual(an investor or a business) loses by choosing one option instead of another.
In theory, the concept seems straightforward to understand and you shrug it off saying, “yeah, I get it.” But many fail to notice the cost they pay by making one decision instead of another. And the cost isn’t always in terms of money. You might pay the price with effort, time, energy, and health.
How to calculate opportunity cost?
Let’s do a short exercise to check if you can calculate the opportunity cost in the below scenario.
Olivia works as an accountant for a large firm. For the last couple of years, she has been considering quitting her job to pursue an MBA full time. The program she’s looking at takes two years to complete and cost 25,000 per year on fees and expenses.
If she decides to go for it, how much will she incur as the total cost?
Did you guess 50K as the total cost incurred for the two years(25,000*2)? If you did, you failed to identify another cost she has to pay by making that decision. By pursuing an MBA full-time, she loses her current salary too. Assuming that the accounting firm pays her 40,000$ per annum, her opportunity cost is 80,000$ in forfeited salary.
Her total cost of opting to study MBA is therefore 130K, 50,000$ in expenses and 80,000 $ of opportunity cost.
After her MBA if Olivia finds a job that pays her an additional 10,000$ annually, she needs 13 years to earn the total cost she paid for her MBA.
When people make decisions, they fail to take such factors into account.
The total cost of making is decision is the sum of the actual expenses and the opportunity cost.
The formula for opportunity cost
So how does one calculate the opportunity cost using a formula? It’s far simpler than you think.
Opportunity cost = Return on the best option – return on chosen option
The usage of the word “best option” is debatable because you won’t always have a clear favorite. At times, you’ll have to pick between choices that have pros and cons of their own.
For example, a college pass-out, Fredrick, has bagged two job offers. One is at a startup that pays 50,000$ per annum and the other is at a larger organization that pays 60,000$. By working at a start-up, he learns and upskills himself faster, but at the bigger organization, he earns more. Such scenarios do not have a clear “best option” because the ideal choice is subjective.
If Fredrick chose the job at the startup, we can apply the formula for opportunity cost as follows:
Opportunity cost =60,000 – 50,000 = 10,000$.
But, if he chose the corporate, the opportunity cost isn’t a monetary figure, but the opportunity lost to learn faster.
When you face straightforward scenarios as Fredrick did, your mind calculates the opportunity cost by itself even if you haven’t heard the term before. But when the choice involves more than one glaring factor as Olivia did, you tend to make a mistake in the calculation.
When you have multiple options, you must try to calculate the opportunity cost of each of them. The one with the least opportunity cost is considered to have a comparative advantage.
Real-life examples of opportunity cost
1. Investment in the stock market
Investments and risk appetite have a warm relationship. The higher your willingness to take risks, the higher your chances of bigger returns. But, a bigger risk comes with a downside of possible higher losses too. Therefore, each investor has a different investment philosophy. Some stick to safe investments, while some others don’t mind taking a bet to go big.
Let’s say you have two opportunities to invest. One offers a 3% return but makes sure your principal remains safe. The other has the potential to provide a 9% return, at the risk of a possible loss too.
If you choose the safer investment, your opportunity cost is calculated as follows: 9%-3%=6%. By making sure you keep your investment amount safe, you forego a potential additional return of 6%.
2. Pursuing entrepreneurship by quitting a job
Many people dream of running their own business but only a handful actually do. That’s because entrepreneurship requires a person to take the risk of quitting a job with the hope of accomplishing a vision.
Taking that leap of faith isn’t comfortable and one has to be prepared for obstacles, hardships, and failures. Because everyone knows how scary, risky, and arduous the entrepreneurial journey is, most prefer to remain within the safe realms of a paid job.
If you quit your job to start a business of your own, the opportunity cost is the salary you lose. The total cost incurred is the sum of your business expenses and the salary you forfeited. If you earned a salary of 40K$ per annum and spent 100K$ over 2 years on running your business, the total cost for making the decision is:
Total cost of entrepreneurship = Expenses + Opportunity cost
= 100K +40K*2 years = 180K$
That’s the cost you pay for trying to live your dream with a hope for a better tomorrow.
If you stick to your job even if you want to become an entrepreneur, the opportunity cost is losing the chance to run a business of your own and being your own boss.
3. Routine decisions
Opportunity cost plays into the little decisions in life too but seldom do people bother to consider it. Here are a few examples:
You’re a student, and you decide to visit the mall before the day of your exams. The two hours of arcade games cost you 30 dollars. The total cost for the decision is the expense of 30$ and the two hours spent on recreation which could have been used to study.
If you have 30$ to spend on lunch, your choice of a restaurant involves a cost that isn’t monetary. Picking one option between continental and chinese implies you lose the opportunity to relish the other cuisine.
If you spend 1000$ on a vacation, you lose an opportunity to invest the money in a savings account or mutual funds. Choosing to save the money involves the cost of forgoing an opportunity to relax, refresh and rejuvenate with family or friends.
An important pointer here is that the existence of opportunity cost doesn’t make one choice better than the other. When you have to choose between two decisions, an opportunity cost exists one way or the other, tangible or intangible. What is best for you depends entirely on your circumstances and your thought process.
How to account for opportunity cost in your decisions
Putting a value on money is straightforward and most people can do that with ease. But, do you put a value on your time? Every time you spend time to save money, you’re paying a cost too. Sure, it doesn’t involve money, but you lose a commodity which you will never get back – time.
Let’s say Ben earns 4000$ a month working as a freelancer. His to-do list contains two pending tasks.
1. Paint the bedroom
2. Distribute pamphlets
After slogging for hours and putting in extra effort over the weekend, he manages to check them off his list. But, could he have approached the tasks a better way? Yes indeed. All he had to do was consider opportunity cost.
At 4000$ a month, his hourly wages come to 25$. A painter charges about 50$ an hour, so choosing the do the painting himself saves him 25$ an hour. But what about distributing pamphlets? He could have outsourced the job for less than 25$ an hour and spent the time working instead.
Doing the painting himself made financial sense, but distributing pamphlets did not.
Let’s replace Ben with Bill Gates instead. Now, does it make sense for Bill Gates to paint a room or distribute pamphlets? Of course not. That’s because his time is more valuable and he’d be better off paying someone else to do the job even if he knew how to paint like a pro.
Now, replace Ben and Bill Gates with you. Next, replace painting the room and distributing pamphlets with your activities. Are you working on tasks that you could outsource? It’s time you started thinking.
If you haven’t put a value on your time yet, it’s time you did. The article helps you make an informed decision on choosing time vs money the right way.
Here are a few questions to help you get started:
- Which activities consume most of your time?
- Do you have to perform these tasks yourself or can somebody else do it for you?(even if it involves a cost)
- If not, is there a long term benefit by training another person to do your routine tasks?
- What are some of the activities you can cut off from your schedule to make time for things that matter to you?
The concept of opportunity cost is simple in theory. The tricky part is that because it is easy to apply, it is also easy to ignore. No matter how small the decision you’re making, take a moment to pause and evaluate the cost of making a choice. With a little practice, it’ll become second nature.
Now that you have understood how opportunity cost works, you have a decision to make. You can choose to apply it or you can ignore it. Which one will you choose?
Maxim Dsouza has spent over a decade experimenting and finding various time management techniques to improve his productivity. He strongly understands the fact that time is a limited commodity and tries to make every second count. He has extensive experience in leadership in startups, small businesses, and large corporations.
He has helped people of different professions and age groups gain clarity on their goals, improve focus, revise their time management skills and develop an awareness of their psychological cognitive biases.