When it comes to common financial principles used by investors and professionals, the term “opportunity cost” is used often. Opportunity cost is the value of the alternative option you’ve given up after making a choice. For instance, the opportunity cost of buying an expensive car would be the money you could have spent on a summer vacation, padding your retirement savings, boosting your child’s college education fund or something else.
“You only have a certain amount of money. Every ‘Yes, I’ll buy’ comes with a ‘No, I can’t buy,'” explains George Krueger, the co-founder of the coaching and e-learning firm BIGG Success and an adjunct lecturer of entrepreneurial finance at the University of Illinois–Urbana-Champaign. “For example, if you say ‘Yes’ to a newer, bigger home, you are saying ‘No’ to other things. What are they? Perhaps you won’t be able to go out to dinner with friends for a couple of years,” he says.
While predicting that you may curtail your entertainment and other discretionary expenses after buying an expensive home, the value of the potential lost opportunity isn’t always so obvious. For this reason, experts stress the importance of factoring explicit and implicit opportunity costs into the equation.
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Explicit vs. Implicit Opportunity Costs
Financial experts often drill down opportunity costs further to analyze explicit versus implicit opportunity costs. This is key for making a smart financial decision, because looking at both types of opportunity costs allow you to see the full picture of potential gains or losses from a purchase. While an explicit opportunity cost is clear-cut (think: spending $50,000 on a sports car and giving up the chance to spend the money on something else), an implicit opportunity cost is the money you could lose by investing in the sports car. If you kept your old car, you could instead invest $50,000 into the stock market and earn a hefty profit. Or you might invest the $50,000 into starting a business that could eventually make you millions of dollars. Of course, you might also lose that $50,000 in the stock market and see the business fail.
When trying to calculate the opportunity cost for a given purchase or investment, it’s important to keep in mind that you can’t predict the future. Still, the opportunity cost is worth considering if you’re contemplating spending a lot of money, and you’re unsure about your decision, Krueger says. Thinking about the opportunity costs will always put a planned purchase in a new light, he adds.
“You may still move forward but now you have its full cost — financial and emotional — in mind,” Krueger says. “Consider the trade-offs to stay true to your goals and your values.”
[See: 10 Expenses Destroying Your Budget.]
How to Calculate Opportunity Cost
Though there’s no magic formula for calculating opportunity cost, it’s important to think through possible scenarios so that you make an informed decision. Use this equation as a guidepost: The revenue of the most profitable choice that you don’t select minus the revenue of the purchase you pick equals the opportunity cost.
Chandra Adusei, the founder and senior managing partner at Veteran Wealth Partners, a financial advocacy firm for military- and veteran-owned small businesses in Escondido, California, recommends that you think of the pros and cons of financial decisions and ask yourself three questions: How does this support my short-term goals for one to two years in the future? How does this support the lifestyle I want for myself in three to 10 years from now? How does this ultimately support the lifestyle I want for myself and my family in 10 years and beyond?
She offers the example of going on a getaway later this year. “If you have a short-term goal of going on vacation within the year, then you probably have to allocate a percentage of one month’s income for the trip or you have to save a percentage of your income over the next several months to pay for the trip,” she says. “The pros of this decision: You will be able to enjoy much-needed R & R. The cons of this decision: You may need to cut back from getting lunch from your favorite restaurant every day so that you don’t come up short every month to meet your monthly vacation savings goal.”
In this case, you may decide to take the vacation. But on the other hand, you may realize you won’t have to just cut back on meals out, but also put off a kitchen renovation and some dental work, and so you decide the opportunity cost is too great.
When looking at an opportunity cost, it’s important to think about the long-term cost, Krueger says. He also says that you can do this with smaller purchases as well, and that can be edifying. “Before you start a daily, weekly or monthly financial habit, think about its real cost,” Krueger says. “We tend to only factor in the price today. What if you considered its long-term cost as well?” He offers up an example of going out with your friends for dinner and drinks on Friday.
[See: 10 Steps to Achieve Financial Freedom.]
“You rack up a $100 bill. If you do that every week — over the course of a year, that’s $5,200. Over 10 years, it’s $52,000,” Krueger says. “You can see that it’s not a $100 decision; it’s a $52,000 decision — not counting the money you can make on this money.”
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What Is Opportunity Cost? originally appeared on usnews.com
