Determining your opportunity cost on any given day and in any situation produces a harvest of beneficial returns, not just financially but in other areas of your life as well, including your mental, spiritual and physical growth.
In the following article on opportunity cost, we will dive into the the concept as well as the philosophical mindset and financial discipline that must accompany it, so you can maximize your life and produce yields that far outweigh the initial seed you planted.
What is Opportunity Cost?
Your opportunity cost can be defined as the benefit you choose to forego when deciding on a different path. Your opportunity cost may be money and resources, but it is also relates to your time. If you choose to spend your money for one thing, then you forego spending it on another. Similarly, if you choose to spend your time in one way, you are foregoing the opportunity to spend your time another way.
You see, life is one big opportunity cost, each day, every day. We are constantly assigning value to that which we choose and lesser value to the opportunity not chosen; we say “yes” to one thing and “no” to many other things.
As you are reading this article you are trading your time to gain insight into our thoughts on opportunity cost. Your opportunity cost is the opportunity that you gain deeper insight at the cost of your time.
So, with that in mind, we will do our best to make this article worth your time, so you do not go away thinking the opportunity was not worth the cost. And we invite you to leave a comment below on whether or not we achieved our goal and how we can go about increasing the value of this article for future readers.
Calculating Opportunity Cost
There is no single formula used for calculating opportunity cost. The concept of opportunity cost reflects the fact that, given a limited number of options or resources of whatever type, choosing one option means giving up the opportunity to choose another.And it may be multiples of another, where choosing 20 of option X means you must give up 40 of option Y.
For a calculating opportunity costs example, suppose you are a healthy 30 year old who wants to buy a $50,000 BMW to impress your friends and family. And assume you pay all cash, rather than choosing to finance your vehicle, (which would result in an even higher opportunity cost than in our example).
By purchasing a $50,000 dream car at 30 years of age, you are foregoing the opportunity of using that money elsewhere. And if that money were to earn 5% return over the remainder of your lifetime, your opportunity cost is $573,370 that you traded in for your shiny new car.
Using a simple cost-benefit analysis on the above opportunity cost example allows you to see the long term ramifications of your financial decision. Now granted, perhaps the BMW is needed and it creates value, or the perception of value, that benefits you in some tangible way. But if your shiny car is simply a status symbol, a simple cost-benefit analysis would lead you to foregoing the BMW today for the benefit of what that money can produce for you in the future.
Opportunity cost is theorized as an either/or proposition, where your decision leads to making a choice for one thing at the cost of the other thing. But as we will go into further below, opportunity cost may also be an AND, where the two choices meet at a future point in time for those who have the discipline to delay gratification in the present.
Opportunity cost applies to resources and assets primarily in terms of money, items and time. But withing each opportunity cost can be any or all three and how they correspond to your specific action or inaction.
An opportunity cost formula that can be used to express the opportunity cost relationship is as follows:
You can define opportunity cost as what you are giving up vs what you are gaining i.e. trade offs vs acquisitions.
For example, if I trade my time that I could have spent working on my business for spending that time with my kids, I am acquiring the opportunity to spend time with my kids at the cost of working on my business.
You see, opportunity cost is about assigning value to a myriad of potentialities and choosing the option that has the most value to you. Value is often relative and what is valuable to you may not necessarily be seen as valuable to me.
Production Possibilities Curve = Achieving Balance
Opportunity cost increases or decreases for a given choice as you move up and down the production possibilities curve. So in the above example, the more time I spend with my kids, the less valuable that time may become to them and the more costly the time is to me in relation to growing my business.
The key is to try and find balance in relation to cost vs opportunity. So in the above opportunity cost example, you would want to make sure that you are not neglecting your business but you are spending valuable time investing in your relationship with your kids.
Determining where the two decisions meet on the productions possibilities curve that maximizes your time spent on both endeavors is crucial if you are seeking to strike a balance between the two choices.
One last thought here before moving on, what if you were to incorporate your kids into your business, so you can accomplish both? In that case, you may have enlarged your production possibilities curve.
You see, innovative ideas and technology can grow your production possibilities curve so that you can accomplish more with your time that previously thought. The moral of the story, don’t settle for simply either/or, try and find the AND. (More on this idea to follow below).
Another Opportunity Cost Example
The easiest opportunity cost examples are often considered in terms of financial decisions because you have a set number of known variables and resources.
For instance, if you have $10,000 to invest and you decide to invest it in Bitcoin instead of Apple stock, using the formula above, the opportunity cost is $1 invested in Apple stock per $1 invested in the Bitcoin. It takes time, of course, to determine whether an opportunity cost decision such as this was the right one.
In the example above, if Bitcoin provides a return of 10% a year over the next 10 years, while Apple stock only returns 5%, the decision would seem to be a good one. If the returns were reversed, you would have been better off investing in Apple instead of Bitcoin.
Now, can we achieve some balance between the two? At which point does investing in one choice make more sense than choosing another? And what if both Bitcoin and Apple stock perform poorly? What opportunity did I miss out on while I was focusing on Apple stock and Bitcoin? For example, perhaps real estate would have provided a higher return, particularly when considering the ability to leverage your purchase with other people’s money.
Obviously we cannot know all the variables. That is why opportunity cost is often the choice for one thing, at the cost of many alternatives. The best we can do is true and assess the pros and cons of our current opportunity and make a smart decision based on our known data.
Instant Gratification vs Delayed Gratification
To achieve greatness in life requires a successful blueprint built on proven techniques and habits. Developing a habit of constantly weighing your opportunity costs will help you develop this skill and maximize your resources, such as time and money.
Developing strong habits requires more than just knowledge, it also requires the ability to avoid the temptation to seek instant gratification by spending the money you make as soon as you make it. To improve your financial position over the long run, financial discipline must be achieved that allows you to accurately assess the opportunity cost of your decisions in an efficient manner.
Deferring gratification refers to postponing certain behavior such as the consumption of goods or services and the expenses and time associated with that consumption today, perhaps enabling you to set aside the resources that would be necessary to acquire those goods or services for later use.
Delayed gratification also requires a longer time horizon than mere days, weeks or even months. It looks out over a period of years to determine if the choices and habits you make today are going to benefit you the most in the long run.
Certainly, you can go too far in the direction of postponing current expenditures to save for the future but, generally, if you devote an excessive amount of your spending to immediate gratification, it can damage your ability to prepare for future spending needs.
This is an particularly important point for those who are trying to plan for retirement – if you hope to retire from your job, or at least work less, in your later years, setting aside money now is essential to help you maintain a standard of living you find acceptable in retirement or semi-retirement.
For example, using life insurance as your personal banking system requires that you fund the policy for a period of time before you begin making loans from your policy. If you do not give your banking policy enough time to build you are potentially impacting maximizing your policy’s long term compound interest growth.
Now, when it comes to deferring gratification, you don’t necessarily have to look at making extreme changes to your current living standards. Even small changes to your spending habits can have a large impact, given enough time.
Eating Out Example
For another opportunity cost example, think about paying $7 for the opportunity to eat out every day. It is inexpensive for a day or two, but using the opportunity cost formula above, you would divide the cash spent to buy the meal by the experience of eating your favorite choice, with the result being that paying $7 per week day for your favorite meal over the course of a year means that you are giving up roughly $1,825 per year (260 days +/- for any overtime) for the privilege of grabbing some fast food at lunch.
While this may not seem like all that significant an expenditure in the big scheme of things, you can use an online future value calculator to calculate that if, instead of buying a daily meal at lunch, you invested the $1,825 at a 5% growth rate, you would have amassed over $25,000 after 10 years.
And in 15 years, your annual interest growth alone would be greater than your contribution amount of $1,825.
Finally, over 30 years at 5% your annual $1,825 investment would have grown to over $129,000.
Can you do better? Imagine if you simply brought a meal to work and paid $3.50 a day instead of $7.00, or ate out every other day, spending on average $3.50 a work day, your savings of $912.5 a year invested over 30 years at 5% would net you savings of over $65,000.
So, by running some basic calculations you can see what the opportunity cost of your daily lunch run is costing you over the long run. And when you take the time to put your spending habits into perspective it can help you make better financial decisions. And don’t stop here, make an inventory of your monthly expenditures and see where your money is going, in an attempt to enhance your wealth building abilities.
Using Opportunity Cost to Decide When to Defer Gratification
The latte example shows that even deferring small expenditures can dramatically improve your ability to amass substantial savings for future gratification, built on a foundation of discipline that has far reaching ramifications for every area of your life. Understanding this provides you with a powerful tool for making good financial decisions.
By examining the expenditures you make on a regular basis from an opportunity cost perspective can be a good way to improve your financial situation without having to make a major lifestyle change.
What are some other potential sources of opportunity cost decisions you can look at? This will vary by individual, of course, but some general areas to investigate include:
- Regular expenditures of money on “treats” such as candy, ice cream, cookies, etc.
- Leisure time expenditures on books, videos, music, or movie downloads, etc.
- Entertainment expenses using both time and money such as going out to see a movie, dinner, play, concert, bar, etc.
- Impulse buys using money for things such as clothing, jewelry, games, home furnishings, etc.
Your Thoughts Matter
Simply denying yourself things is not the path to prosperity. The true path to wealth and prosperity begins when you start thinking correctly about money.
Instead of thinking of it as denying yourself immediate gratification, change how your money paradigm. Consider the opportunity cost of your purchases. Ask if your purchase or time use is benefiting you in anyway. And consider how you might be able to choose a better, more beneficial route.
For example, since you already budgeted the $5 daily for Starbucks, maybe you brew your own coffee at home and save $4 a day. Now you have an extra $4 a day that you can put into an investment, such as a robo advisor or life insurance policy.
The result? Not only are you saving $4 a day, but your investment has the opportunity to grow substantially overtime thanks to compound interest. So that $4 you saved by not spending on a Starbucks coffee, has an opportunity to grow into a sizeable fortune that you would have never experienced if you did not weigh the opportunity costs.
By taking a more intentional, systematic approach to your daily spending habits, you can create new habits that focus more on long term growth, rather than immediate gratification. Over time, the decisions you make today, will have profound impact over the course of your life. Take the time today to educate yourself and establish the habits necessary to transform your character into that of someone who will one day change the world for the better.