When making financial and business decisions, it's important to weigh all of your options, even those that are not immediately apparent. One thing you need to take into consideration when making choices is the opportunity cost, which is the profit that you forego by passing on an opportunity—the consequence of selecting one choice over another.
It's important to know the definition of opportunity cost, how to spot it, and how to calculate it to learn how to deal with finances wisely. Let's take a closer look at this financial concept and how to compute for opportunity cost.
What is opportunity cost?
The concept of opportunity cost entails looking at the value of the next best alternative that you give up when you make a choice. It's what you sacrifice to get something.
While opportunity cost is often thought of as a financial concept, it can also be applied to non-financial decisions. For example, you have a good job with a steady income, but your dream is to open your own business. This would require you to leave your current job and spend a lot of money on the initial startup costs. You have to weigh both options carefully. If you choose a steady job instead of opening your new business, then you miss out on the work that you wanted and possibly, the success that comes with it. However, if you start your business, then you forego the stability of a paycheck from a regular job.
Opportunity cost is an important concept to understand because it helps us make better business and wealth management decisions by taking into account all of the potential options and trade-offs. By understanding opportunity cost, we can weigh the pros and cons of different choices and choose the option that provides the most benefit.
How do you compute opportunity cost?
The opportunity cost formula allows you to establish the difference between the expected returns (or actual returns) of two options. This equation is useful in two different cases: You can use it to gauge the effect of an impending decision, or you can calculate the gains and losses of past decisions. Use this straightforward formula to calculate the opportunity cost of a possible business venture:
Opportunity Cost = FO − CO
where:
FO = Return on best forgone option
CO = Return on chosen option
What is the difference between opportunity cost and sunk cost?
In business, opportunity cost is often used interchangeably with sunk cost fallacy in finance, but they are not the same thing. When making financial decisions, it's important to understand the difference between sunk costs and opportunity costs to make better financial decisions. A sunk cost is money that has been spent and can't be recovered. An opportunity cost is a potential return that can no longer be earned because the capital was invested elsewhere. So, with opportunity costs, you typically look at things you miss out on from not making these investments.
What are some examples of opportunity costs in real life?
To illustrate the concept of opportunity cost, let’s look at people’s common dilemma: to rent or to buy a house.
Let's say you're trying to decide whether to buy a new car or invest in stocks. The opportunity cost of buying a new car would be the potential return of investing in stocks. In this case, you're giving up the chance to earn money to buy a new car.
On the other hand, the opportunity cost of investing in stocks would be the fun and convenience of having a new car. If you choose this option, you give up the chance to have a new car for the chance to grow your money.
Another example might be if you're trying to decide between two jobs. One job pays more money but requires more hours, while the other job pays less money but has more flexible hours. Your opportunity cost would be the salary difference between the two jobs multiplied by the number of hours you would work at each one.
As you can see, opportunity cost is often about more than just money. It's about weighing all the factors involved to make the best decision for you. While not all returns have a corresponding figure, you can use the principle for computing opportunity cost to compare your choices.
How does opportunity cost affect budgeting?
Opportunity cost can have a significant impact on how to budget money. It can help you develop good money habits. It encourages you to take the time to consider the opportunity cost of your choices to make sure you get the most bang for your buckk.
When deciding whether to buy or rent property, you consider the money lost from making a down payment instead of investing, as well as forfeiting the chances to move easily and take a job in another country. The opportunity cost of renting a house, on the other hand, is that the rent can be much higher than the monthly amortization. This means that you could be paying a lot of money every month just to keep a roof over your head, but you have more flexibility when it comes to making other decisions in your life.
Both choices have trade-offs, and it's up to you to decide which option is best for you based on your unique circumstances and goals.
Looking for opportunities to grow your money?
Understanding the meaning of opportunity cost is key to making wise financial decisions. By taking into account the potential costs associated with each choice, you can get the most value for your money.
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