Have you ever grown impatient at the extreme couponer in front of you holding up the line? Why do people bother? It is because they know how to calculate opportunity cost and have determined it is worth their time. There are a few methods for how to calculate opportunity cost. For some, it is the ratio of what they sacrifice and what they gain. For businesses, it is usually total revenue less economic profit.
It is important for both businesses and individuals to know how to calculate opportunity cost, so they can make the sound decisions. The scope of this article includes discussing what opportunity cost is, when it should be calculated and how to calculate it.
What Is Opportunity Cost?
The biggest part of understanding how to calculate opportunity cost is to understand what opportunity cost is. Individuals usually think of opportunity cost as what you sacrifice divided by what you gain. For example, you can be a CPA and get paid $150 per hour or not earn this title and make $10 per hour.
In this example, your opportunity cost of not earning your CPA is $15. In other words, for every dollar you earn as an accountant without your CPA, you give up 15 dollars. Avoid the mistake of thinking you are giving up $135 per hour by not having your CPA. However, money is not the only factor in learning how to calculate opportunity cost. The costs associated with decisions can either be explicit or implicit and relate to time and effort or sweat equity as well.
People often wonder if they should seek post-secondary education after they get their Bachelor’s degree. Let’s look at the explicit financial opportunity cost of attending grad school. You have costs such as tuition, textbooks and lab fees. Room and board are not explicit costs of attending grad school. This is because you would have to pay rent and feed yourself whether you attended school or not.
Using the same example as above, there are implicit opportunity costs for attending grad school. These costs require no capital outlay so are difficult to calculate. You are giving up the opportunity to work a salaried, professional job to go to class. The time you spend studying is time you cannot spend working an hourly, part-time job.
Perhaps Malcolm Turnbull put it best when he said, “One of the most important concepts of economics is ‘opportunity cost’ – the idea that once you spend your money on something, you can’t spend it again on something else.” This helps you to view your decisions in terms of scarcity. If you choose an option, you may have to hold off on other things you want to do based on the limitation, or scarcity, of resources.
Examples of When to Calculate Opportunity Cost
You need to know how to calculate opportunity cost whenever you need to decide whether pursuing an activity is worth your time or not. You should also calculate opportunity cost when investing. Be honest when calculating opportunity cost to determine if an activity is worth your effort.
For example, you could save $12 by spending an hour cutting coupons. You cannot say if you had not been cutting coupons you could be making $30 per hour working if you would not have actually spent that time working.
Calculating opportunity costs when investing is tricky because your returns are not guaranteed. Imagine you have $20,000 to invest in either a CD with a 3% annual return or stock with an expected 7% return. You invest the full $20,000 into the stock market because it looks like the opportunity cost of investing in the CDE is 4% annually. However, if your stock only provides returns of 2% in a year, you missed out on 1% of returns by not investing in the CD.
Pursuing certifications is another great time to calculate opportunity cost. Let’s say you need $2,000 to earn your CPA. The explicit testing cost is $2,000, and the implicit cost is the hundreds of hours you will spend studying rather than watching Netflix, working out or sleeping. At face value, it may seem like getting your CPA is a poor option due to all the effort you have to put in. But where can that certification take you in life?
You could find a public accounting firm that will give you a $3,500 sign-on bonus for having your CPA. After considering the up-front cost, you are giving up $1,500 to not obtain your CPA. Then you have to consider the future earnings you are missing out on by not obtaining your CPA. If you can make an average of $55,000 annually without your CPA or $80,000 annually with your CPA, you are missing out on $25,000 per year you work by not obtaining your CPA.
Businesses always need to know how to calculate opportunity cost because every decision they make will affect their bottom line. Let’s look at a simple example. A bakery has flour, eggs, sugar, salt, and baking powder. The baker can make cupcakes which cost $2 to make and sell for $6 or cookies which cost $2 to make and sell for $4.50.
The opportunity cost, in this case, is for every $2.50 of profit made selling cookies, the business sacrifices $4 of profit to sell cupcakes. The risk of baking cupcakes over cookies even though they are more profitable is people may prefer cookies over cupcakes and choose to not patronize the establishment.
How to Calculate Opportunity Cost
There is not a single mathematical formula for how to calculate opportunity cost. However, when individuals calculate opportunity cost, they usually calculate the ratio of what they sacrifice to what they gain.
When learning how to calculate opportunity cost, there are some terms you need to understand. These include comparative advantage, the law of increased opportunity cost, sunk costs, tradeoffs, and risk.
Comparative advantage is an economic concept typically used by businesses. It usually means an economy or company is producing more services or goods for less of an opportunity cost than competitors.
For example, Cambodia can make a pair of Nike shoes for $33. The United States can make that same pair of shoes for $75. In this case, Cambodia has a competitive advantage over the United States of $42 per pair of shoes.
The Law of Increased Opportunity Cost
The law of increased opportunity cost can occur even if you spend nothing. Say you consider making homemade tortilla chips or buying them at the grocery store. You already have flour, salt, lard and baking powder on hand, so you do not have to go to the store. You can make your chips, the ancillary costs of which are using gas or electricity to cook, ingredients that can now not be used for anything else and time.
Sunk costs are expenses which have already been incurred. For example, if you spend $12,000 on a motorcycle, that is a sunk cost. When calculating opportunity cost, you should not consider the sunk cost. The fact that you spent the money on the motorcycle is irrelevant to the opportunity cost of getting your brakes fixed vs. selling the bike vs. doing nothing.
A trade-off triggers you to calculate opportunity cost. The trade-off of not getting your bike’s brakes serviced is you can invest your money in the stock market. This is based on the premise that you can only spend your money, time and effort on one thing.
Risk is different than opportunity cost. It is defined as potential harm that could occur based on lifestyle, financial or business decisions. If you invest $300 in the stock market instead of getting a brake job for your bike, you risk the potential of rear-ending a car, losing your money in the stock market or other events.
Once you know how to calculate opportunity cost, you can make better decisions and get closer to your goals. The three things you need to remember in how to calculate opportunity cost is money, time and effort. How much cash do you have to part with to get what you want? How much time is it going to take? What else could you be doing with this time? Where else could this effort be spent?
It’s vital when calculating opportunity cost not to count sunk costs. These expenses have already been incurred, cannot be changed and have no place in your calculations. The most common method for how to calculate opportunity cost is to divide what you sacrifice by what you gain. If you could make $150 per hour but are only making $10 per hour, you are sacrificing $15 for every dollar you make. Another method for how to calculate opportunity cost is to look at the difference between the best financial option and the next best option.
Both businesses and individuals need to determine the opportunity costs of decisions to ensure these are the best for reaching their goals. Spending $2,000 and hundreds of hours studying to get a professional certification may seem like a poor choice until you sit down and realize this certification can earn you an additional million dollars throughout 40 working years. The bottom line is, to ensure you are making the best decisions, sit down and consider honestly how your actions will affect your life based on finances, time and effort.
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