Imagine you have two job offers: one promises a higher salary, but requires more hours, while the other offers more flexibility, but a lower salary. How do you decide which one is best? How do you figure out opportunity cost?
Understanding how to calculate opportunity cost can be your secret weapon in making a wise decision.
In this article, we will delve into the concept of opportunity cost. We will also see how the cost can be calculated in various situations and why it is crucial for making a decision in various areas of life.
Whether you’re considering investment options, career paths, or even weekend plans, mastering the concept of opportunity cost can help you make decisions that are more profitable in the future.
What is opportunity cost?
The concept of opportunity cost refers to the value of the next best alternative that you give up when making a decision. Basically, it’s what you give up to choose something else.
Let’s say you’re planning a weekend getaway with friends. Option A is a trip to the beach that costs $500, while option B is a trip to a mountain cabin for $400.
You’re excited by the idea of sun and sand, so you choose the beach retreat. Then you realize that the mountain cabin was not only cheaper, but also offered hiking trails and stunning views that you would have loved to see.
In this scenario, the opportunity cost of choosing the beach retreat is not only the extra $100, but also the lost opportunity to experience the mystique of the mountains.
The next time you have to make a decision, whether it’s about a vacation, choosing your next job or investing in stocks, remember to calculate the opportunity cost. It’s not just about what you gain from a decision, but also what you give up by choosing it. Knowing how to figure out opportunity cost will help you compare options more intelligently.
How do you figure out opportunity cost
Calculating the opportunity cost to achieve higher future profitability is a simple 4-step process.
- Identify the options: Determine the two or more alternatives to consider. Let’s call them Option A (chosen option) and Option B (next best alternative).
- Assign them values: Assign a numerical value to each alternative based on its benefits, profits, returns or any relevant metric. This could be monetary (e.g. dollars, euros) or non-monetary (e.g. time, satisfaction).
- Calculate the difference: Subtract the value of option A (chosen option) from the value of option B (next best alternative).
- Interpret the result: The resulting number represents the opportunity cost. A positive value indicates the benefit you lose by not selecting the second alternative, while a negative value means that the value of option B is less than that of the chosen option.
Opportunity cost formula
To put the process into practice and understand the opportunity cost formula, let’s consider an example. Let’s imagine again that you have to decide between two job offers.
- Job Offer A: Salary of $60,000 per year.
- Job Offer B: Salary of $50,000 per year.
To calculate the opportunity cost of choosing Job Offer A over Job Offer B we assign the following values:
- Return on next best alternative (Job Offer B): $5,000
- Return of the chosen option (Job Offer A): $6,000
Then, we calculate the difference and interpret the result.
- Opportunity cost: $5,000 – $6,000 = -$1,000
In this situation, if you choose Job Offer A instead of Job Offer B, the opportunity cost is -$1,000.
The negative opportunity cost indicates that the return on job offer B is $1,000 less than that on job offer A, making job offer A the more financially advantageous option.
10 examples of opportunity cost
Now that you know how to figure out opportunity cost, you can apply it in different areas of your life. After all, the concept of opportunity cost is relevant to all types of choices, from an economic decision to the way you spend your time.
These examples illustrate how opportunity cost can vary depending on the alternatives considered.
- Investment decisions: Choose to invest $10,000 in Share A with an expected return of 8% per year instead of Share B with an expected return of 10%. Opportunity cost: $200 per year ($10,000 * (10% – 8%)).
- Education options: Decide to obtain a master’s degree that costs $30,000 and not work rather than starting a job immediately with an average starting salary of $50,000 per year. Opportunity cost: $50,000 per year.
- Time allocation: Dedicate 10 hours a week to freelancing earning $40 per hour instead of using that time to develop your own business that could potentially earn $500 per week. Opportunity cost: $100 per week.
- Rent or buy: Choose to rent an apartment for $1,500 per month instead of buying a house with a mortgage payment of $2,000 per month. Opportunity cost: $500 per month.
- Career options: Accept a job offer with a salary of $80,000 per year in a less desirable location instead of a job offer with a salary of $75,000 per year in a preferred location. Opportunity cost: -$5,000 per year.
- Expanding a business: Deciding to expand a business by investing in new equipment that would bring in $40,000 in additional income rather than hiring staff that could increase income by $100,000 per year. Opportunity cost: $60,000 per year.
- Overtime Opportunity: Choose not to work overtime and earn an additional $300 per week, so you can spend time with family. Opportunity cost: $300 per week.
- Travel decisions: Opt for a holiday package that costs $5,000 for a week instead of a less expensive package that costs $3,000 for the same duration and similar experience. Opportunity cost: -$2,000.
- Investment in training: Spend $2,000 on a professional training course instead of using that money to invest in stocks that could potentially generate a 20% return annually. Opportunity cost: $400 per year ($2000 * 20%).
- Buying a car: Buying a new car for $40,000 instead of a reliable used car for $20,000. Opportunity cost: $20,000.
Conclusion
Understanding how to figure out opportunity cost will allow you to make more informed choices in the personal and professional aspects of life. By recognizing what you stand to gain and lose when making a decision, you will be able to navigate through dilemmas more effectively.
Remember that every decision has its advantages and disadvantages, and being aware of the opportunity cost will help you prioritize what matters most.
The next time you are faced with a financial, professional, or even daily activity decision, consider the opportunity cost involved. It could lead you to the choice that best aligns with your goals and aspirations.
