Any choice you make has a trade-off. If you choose to have one thing, it usually means you have to forego something else. This trade-off may either be something tangible (like money) or something intangible (like time).
Here’s a simple opportunity cost example: Assume you’veearned $10 and you want to spend it in a mall. You can either buy a movie ticket or eat a chicken sandwich. If you choose the sandwich, you’ll have to forego the joy of watching a movie. If you opt to watch a movie, you’ll have to forego the sandwich. This is the concept behind opportunity cost – trading one thing for another.
As a kid or teen, knowing how to calculate opportunity costs can help youmake good decisions all through adulthood. In this blog, you’ll learn what opportunity cost is and how you can apply it in real-life decisions.
What is opportunity cost?
When making a choice, opportunity cost refers to the value of the best alternative option that you don’t pick. It’s what you give up (or trade off) in order to pursue the thing that you want. When you’re presented with two options, the one you forego is your opportunity cost. If you have more than two, your opportunity cost is the value of the next best option.
Opportunity cost is different fromsunk cost because opportunity costs are not actual expenses. They are simply missed opportunities. Sunk costs areactual expenses that can’t be recovered.
Understanding the basics
The following concepts will help you better understand opportunity cost:
There’s sacrifice:Opportunity cost is based on the fact that you sacrifice something every time you choose one thing over another. If there’s no sacrifice — that is, you’re not giving up anything — then there’s no opportunity cost.
It goes beyond immediate trade-off:Depending on how big the decision is, foregoing one thing for another could have a long-term impact. If, for example, you choose to pursue engineering over medicine, it would change your entire career trajectory. For this reason, opportunity cost means looking beyond what you’re giving up now.
Delayed gratification: Trading one thing for another doesn’t mean you won’t get the other one forever. You may still get it in the future. This is what’s known as delayed gratification. For example, if you decide to save $200 instead of buying a gaming console now, you may still buy the console (as a reward for saving) two or three years later when your savings hit $2,000. Delayed gratification improves your money management skills and ability to save for a goal.
Intangible vs. tangible costs
When calculating opportunity cost, it’s important to understand both tangible and intangible costs. Tangible costs are measurable and include things like material items and money. Intangible costs are immeasurable and include the emotional impact of something, such as feelings of happiness and satisfaction, or the benefit of convenience.
Assume you have a long holiday from college and you’re weighing between taking a paid internship and going on an overseas vacation. You choose the vacation. Your tangible costs include the money you’ll spend on vacation plus the wages you could have made at the internship, while your intangible costs include the missed opportunity to get some work experience and advance your career.
How to calculate opportunity cost: the formula and finding potential opportunities
In business, opportunity cost is calculated mathematically using the following formula:
Opportunity cost = FO – CO, where FO is the potential return on the option not chosen while CO is the return on the option chosen.
So, if a company chooses option A, which brings a profit of $2,000 (this will be its CO) and foregoes option B, which has a potential profit of $1,800 (this will be its FO), you can substitute the values in the opportunity cost formula to get -$200. In this case, the negative opportunity cost means that the company is gaining more than it is losing. If it were positive, then the company would be losing more than gaining by making that decision.
You can use the same concept to weigh different options and figure out which one offers more benefits. First, you’ll need to identify the available options.
List pros and cons
What are the advantages and disadvantages of each option? Figure out what you stand to gain from each option and what you stand to give up if you choose it.
Assess the alternatives
Avoid simply focusing on the one option that you prefer and ignoring the rest. Instead, assess the pros and cons of each alternative with equal objectivity.
Making informed decisions
If you know how to calculate opportunity cost, you’ll make more informed choices.
Analyzing opportunity costs
From your list of pros and cons, decide the benefits and costs — both tangible and intangible — that matter most to you in the short and long term.
Maximizing benefits and minimizing losses
Figure out which choice provides the most benefits and the least cost. Ideally, that should be your preferred choice. Your next best choice is your opportunity cost.
Examples of opportunity cost
Consider the following examples of opportunity cost you might use in your own life.
Education opportunities
Example 1: Choosing to complete your school assignments instead of going out with your friends. The immediate opportunity cost is the missed quality time with friends. If, instead, you do go out with friends, then the opportunity cost is potentially lower grades which can affect your academic performance long-term.
Example 2: Studying in a field that you love over one thatpays a high salary. The opportunity cost is a monetary loss (lower pay in the future). On the other hand, the opportunity cost of choosing a higher pay is less satisfaction or enjoyment at work.
Job opportunities
Example 1: Opting to be self-employed over formal employment. The opportunity cost is the potential work security that comes with a formal job. If you choose formal employment, then the opportunity cost is the chance to be your own boss.
Example 2: Choosing one employer over another. The opportunity cost is the list of benefits that the employer not chosen offers.
Career advancement opportunities
Example 1: Dedicating more time tochase an income at the expense of a healthier lifestyle like working out and taking off days. The opportunity cost may come in the form of health problems. On the other hand, the opportunity cost of reducing your work hours could be a lower pay.
Example 2: Working overtime for a chance at promotion instead of spending time with loved ones. The opportunity cost is the missed chance to spend quality time with the people close to you. If you spend more time with your loved ones, the opportunity cost is the missed overtime income.
Investment/financial opportunities
Example 1: Renting out business equipment instead of using it at the company. The opportunity cost is that the company can’t always use the equipment. If, instead, the company retains the equipment, then its opportunity cost is lost rental income.
Example 2: Overlooking an investment opportunity in favor of saving. The opportunity cost is the missed profit. If you decide to invest instead of save, then the opportunity cost is a potentially low emergency fund.
The final word
Ultimately, learning how to consider opportunity cost will help you make informed decisions in all aspects of your life. By weighing the pros and cons of every option, you can easily figure out which alternative provides maximum benefit at a low cost.
TheGreenlight Learning Center has tons more money, career, and college content. Frommanaging a debit card as a teen tomoney-making ideas for kids, there’s something for everyone.
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