Many times, we seem to have to choose between two things. And there is always one trade-off or the other to make. And we never have all we want because everything in life has an opportunity cost.
Opportunity cost is otherwise known as forgone alternatives. It is the value of that which you have to give up in place of another. It is an economic term or concept that describes the art of better decision-making in life and other situations.
Besides opportunity cost being an economic concept, is there a way to use this type of calculation in your life? Keep reading to learn more.
What is the opportunity cost?
It is one of the foundational concepts in economics and borders on the best-forgone alternative. Usually, it originates from the existence of scarcity and scarce resources. Because human wants are insatiable, people are unable to fulfill or satisfy their needs. Therefore, they must satisfy some at the expense of others. It means that when we pursue one activity over another, the forgone activity becomes the opportunity cost of the pursued training.
How Opportunity Cost Functions
While making decisions, investors try to consider the potential opportunity cost, but the calculation of opportunity cost is much more accurate with the benefit of hindsight. It is easier to compare the return on a chosen investment to the foregone alternative when you have real numbers to work with rather than estimates.
Assume your aunt had to choose between investing in Company ABC and Company XYZ. She decides to purchase ABC. ABC has returned 3% a year later, while XYZ has returned 8%. In this case, she can easily calculate her opportunity cost to be 5% (8% – 3%).
Investors frequently use opportunity cost to compare investments, but the concept can be applied to a wide range of scenarios. If your friend decides to take a year off from work to return to school, for example, the opportunity cost of this decision is a year’s worth of lost wages. Your friend will weigh the opportunity cost of lost wages against the advantages of obtaining a higher education degree.
Types of opportunity cost
Often, the forgone alternative may involve some monetary compensation. Other times, it may not require any financial payment. The former gives us explicit cost, while the latter provides implicit cost. Both types of cost give rise to two significant types of opportunity cost-explicit cost and implicit cost.
This type of forgone alternative usually involves a kind of monetary compensation. Typically, the money payment compensates the one who has incurred the original opportunity cost by forgoing some satisfaction. As a result, the money paid transfers the opportunity cost of the foregone alternative from the person receiving payment to the one making or offering the amount.
A life example that explains the explicit cost
A worker in a company is supposed to be the original bearer of the opportunity cost because the worker has to forgo comfort and time for pleasure. However, because the worker is paid wages, the forgone alternative paid in monetary terms shifts to the employer who makes payment. Therefore, the employer bears the explicit cost.
This type of opportunity cost does not involve any monetary compensation. In this type of forgone alternative, the person who should initially bear the forgone alternative doesn’t get any financial compensation. And the opportunity cost does not shift to anybody since there is no one to pay for it with money.
A life example that explains the implicit cost
A worker who works at his primary job and at the same time works the closing shift at his father’s company. Because he works the closing shift at his father’s company, he does not get to have extra time for leisure. Since his father’s company worker works to build the family enterprise, he does not get any wages. As a result, the forgone time for leisure is his implicit cost.
Opportunity Cost Limitations
The primary limitation of opportunity cost is the difficulty in estimating future returns. You can study historical data to get a better idea of how an investment will perform. No investment can be predicted with 100% accuracy.
The consideration of opportunity cost remains an important aspect of decision making, but it isn’t accurate until the decision has been made and the two investments can be compared.
While the concept of opportunity cost applies to any decision, it becomes more difficult to quantify when non-monetary factors are considered. Assume you have two investment options. One offers a conservative return but only requires you to lock up your money for two years, whereas the other will not let you touch your money for ten years but will pay a higher interest rate with a slightly higher risk. In this case, the differences in liquidity will be included as part of the opportunity cost.
The greatest potential cost in terms of liquidity is the possibility of missing out on a wonderful investment opportunity in the future because you can’t get your hands on your money that’s locked up in another transaction. That is a genuine potential cost, but it is difficult to measure in monetary terms, therefore it does not fit neatly into the opportunity cost equation.
How to calculate opportunity cost
To correctly calculate this cost, we need explicit knowledge of the cost and benefits of all options available. Working out this cost per time guides both individuals and corporate entities in proper decision-making. And sound decision-making brings progress and profit.
Mathematically, we can derive or calculate the forgone alternative by subtracting the return on chosen option from the return on a best-forgone alternative.
How to use opportunity cost calculation in your life.
Trying to use this cost calculation in your life would mean accounting for the forgone alternatives in your life or business. Even though we have an established formula for calculating this cost, most people fail to give it the attention required. The reason is that it is a very abstract concept. As a result, sometimes, it can prove intangible and therefore easy to neglect.
What does an opportunity cost estimate reveal?
You can use opportunity cost to help you with the following:
Calculate missed opportunities
The loss of opportunity is the most important information you can obtain from an opportunity cost estimate. It allows you to see the real-world repercussions of selecting one of two options. Calculating the opportunity cost of investing in new machinery rather than improving old machinery, for example, might assist you in identifying the potential rewards of your investment. Because older machinery may be more prone to breakdown, purchasing new machinery may make more economical sense. Knowing how to spot these possibilities enables for more informed decision-making to maximize resources.
Determine the relative cost of various investment alternatives.
Another advantage of opportunity cost assessment is that it allows you to compare the relative costs of different investments as well as the possible rewards of each. This information enables you to select the investment that provides the greatest benefit to you.
For example, a company may evaluate purchasing two new programmable sewing machines or five used non-programmable alternatives for the same price. After assessing current and projected orders, the company believes that the five old machines are preferable since they can boost output while reducing training time.
Compare the prospective returns on investments
Calculating opportunity costs can help you determine the potential profitability of alternative investments. For example, a company may wish to invest in new equipment or securities. Calculating the opportunity cost of both investments helps illustrate to planners what the business might lose if either option is chosen.
How Paystubsnow helps entrepreneurs manage cost-effectively
As a business owner, because you incur certain costs due to paying employee salaries, it becomes necessary to understand how much you spend. By paying employee salaries, the original opportunity cost of your employees is transferred to you that pays wages. Therefore it is essential to understand how much of the explicit cost you incur indeed.
With Paystubsnow, you can use paystub generator for your employees as well as electronic invoices to stay on top of customer or client obligations. Some other utilities you can derive from the online paystub generator are 1099 and w2 forms. All of which you can get in your email within minutes of generation.
How do you use opportunity cost in everyday life?
We use this cost in everyday life each time we have to make choices and decisions. The fact that we have to always choose one thing over another is the practice of forgone alternatives. As a result, this cost can influence to a great extent vast aspects of our lives, from family life to diet, health, finances, career, and so on. A clear example would be choosing to walk home from work rather than taking the bus. Thus, the forgone alternative is the time you spend walking home because you decided not to take the bus.
How do you calculate opportunity cost?
Because calculating this cost is pretty abstract, it can seem quite daunting to pin down. Regardless, the simplest way to figure it out is to consider what you have to sacrifice or forgo in place of another.
What is the importance of opportunity cost?
It is crucial in executing the best form of decision making, especially considering the scarcity of resources we always have to deal with. That way, we can adequately maximize our little resources for more profits.