When one agrees to participate in something, they are indirectly declining an alternate opportunity, which is referred to as opportunity cost. When you understand the implications of opportunity costs you will significantly change how you view and handle your finances.
Many financial errors or mistakes happened by people who were unaware of opportunity costs and made an ill-informed decision because the costs of the decision were less obvious at the time.
Let’s take a closer look at this and four factors that can help you influence every financial decision you make.
As an example, let’s say you have a small farm and can only produce fruit on your farm.
On your farm you can produce apples (4), oranges (2), bananas (1) and you receive the same price for each fruit. Clearly, if you produce apples you will make the most money.
However, once you pick apples you cannot grow oranges or bananas so the opportunity cost of picking apples is that you no longer have the chance to pick either of the other two fruits.
This hypothetical example illustrates that with every decision you make, you have an invisible or hidden price attached to it.
Every time you make a financial decision (e.g., purchase car, invest cash, or go on vacation), there are four variables you can fact into your analysis:
- Capital allocation
- Time allocation
- Current Cost
- Future Cost
Analyzing your decision from each of these perspectives can help you determine how much you’ve lost in opportunity cost.
Capital allocation simply describes where you allocate your financial resources.
For example, if you spend $3,000 on a vacation, that seems to be an easily identified cost, but the opportunity cost would have been investing, saving or reaching another goal with that $3,000.
After you spend that $3,000 on vacation, you will no longer be able to use that $3,000 for any of those other options that you could have chosen before you spend your money.
This does not mean that vacations are a poor alternative; however, it does mean that every dollar can be used for multiple purposes and every time you spend money you have also eliminated a number of other options.
The next thing to think about is the time you will use.
You can earn more money at any time, but you can’t get back any of your lost time due to a decisions you make.
You can only live for so many hours each day, and you only have so many years of life to live.
If you go take a two week vacation, then you will not have that time to work, to spend time with loved ones, or to build a business on the side.
In the end, sometimes the amount of time you will sacrifice as a result of your decision is worth greater than the financial rewards associated with your decision.
If a person makes thousands of dollars every hour, then spending hours to switch banks for slightly better returns may be of little value.
In such cases, time is worth more than the extra amount they would earn.
An important factor to this equation is present costs.
Present costs are related to the current cost of a decision, the outflow of cash for the purchase today.
For example, when purchasing a vehicle that costs $10,000, the sticker price is what most people will consider when calculating out-of-pocket expenses.
However, by concentrating exclusively on the upfront price, you run the risk of making a poor purchasing decision.
The reason is that each purchase has future costs associated with it.
Continuing with the vehicle purchase example, owning a vehicle doesn’t just impose an out-of-pocket expense at the point of purchase. Owning a vehicle also entails costs over its ownership period, such as insurance, gasoline or diesel, maintenance, taxes, and repairs.
Over time, these costs can significantly increase your overall outlay of $10,000 for the purchase of the vehicle.
In addition, future costs typically are associated with comparing spending versus investing.
For instance, assume someone spent $3,000 on a vacation. On the one hand, they have great memories of that vacation. On the other hand, had they invested the same amount of money at that point, it could have had substantial cumulative returns.
Long-term differences characterize opportunity cost.
Opportunity cost can often prove to be particularly challenging since many people will not make an optimal choice.
Psychology is also an important factor. In many cases, people have “status quo bias” which means they will typically go with what they are already comfortable with, instead of trying something new, often regardless of how much better the new choice may be.
As with the fruit farm case study; if there were technological changes to produce greater profit from banana production than apple production, logic tells me that I would shift my production from one crop to another.
The reality of the situation is, many people resist changing the way they have always done it.
At times, comfort may be greater than logic.
A real-world instance of opportunity cost is found in the ability to refinance your loan.
For instance, you may take out a student loan at a high-interest rate while in school, but once you graduate and find a full-time job you may qualify for a much lower interest rate and you will have an opportunity to refinance.
If you never take the time to research or complete the paperwork required to refinance your loan, then the opportunity cost will be potentially thousands in additional payments of high-interest loan payments to the lender over the life of the loan.
In summary, some small effort today may save you a tremendous amount of money in the future.
The primary point is that opportunity cost is not merely an academic concept or something that is only relevant to economists; it actually impacts every decision made in our daily lives from how we spend our money to how we invest our time.
When you’re confronted with a large financial decision you should take a moment to stop and think about:
- What am I giving up if I go with this option?
- Am I better off with my time elsewhere?
- What will this cost me today?
- What could I pay in the long term?
By asking these questions and really thinking them through can greatly enhance your financial decision-making process.
Because with money, sometimes the actual cost of an item is more than simply the number on the price tag.
