Opportunity cost can be defined as “the value of the choice of a best alternative lost while making a decision.”
Or, more colloquially, it’s “what you could have done if you had chosen differently.”
I’ve talked before that one should consider the opportunity cost. But considering is one thing; how do you calculate the opportunity cost?
I had this put to me in a meeting with someone I was coaching. (Don’t worry, I got her permission before posting here!)
The question concerned an upcoming trip, with a cost of $300. The prospect of warm weather, from the vantage point of a city blanketed by snow, was compelling.
But what would she be giving up by doing this flight of as-it-were fancy?
Figure out if you have the money
You can’t go on the trip if you don’t have the money. Well, technically you can, but it goes against everything we talk about here, so I won’t acknowledge it. If you don’t have the money, stop here.
Figure out where the money will come from
The money will need to come from somewhere. And since a vacation, no matter how desired, is never an emergency, you have only a few options:
- From a savings account (a “bucket“)
- From other bills (usually not possible unless the bill is you paying into a savings account)
- From other expenses categories (perhaps creating an “Adventure” category)
The latter only works if you have enough flexibility in your categories to do this. A $300 plane flight might be possible (think taking away $50 from each of 6 categories) but $2,000 trip probably would not.
Figure out what you would have done
It’s not just removing money from other places that’s important. It’s important to think about what you would have done with that money as well.
Perhaps you were going to put that money away for some purpose. Perhaps you were going to use that money to pay down your student loans. Or a credit card bill. Or a mortgage.
Write out a list of these possibilities. This shouldn’t be too difficult, as you’re by now a private eye toward your money, so you know what it’s going to do.
(A related question, but outside our purview, is what you would have done with that time. That’s an opportunity cost too.)
Figure out the ramifications of not doing everything else
Remember, by saying yes to something, you say no to something else.
So, for example, if you planned to put $300 into your student loan balance, but now are not, what would that mean? For one, it would mean that your balance wouldn’t go down as quickly, and could mean that you have your student loans for one, possibly two more months.
Were you planning on saving up for something else? How far back would that push things?
Go through the list and see what the effects are of this change.
Then sum up each of the effects, and ask yourself if you’re okay with all of them.
Make the decision
This whole process should take no more than an hour. At this point, you’ve not only considered the opportunity cost, but you’ve also calculated it.
But there only be so much deliberation. Eventually you make the call. Do you want to make this happen, or do you want to make other things happen?
(If you’re interested, she went for it. And with a thumbs up from me too.)
But enough about me. How do you calculate the opportunity cost of doing something?
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