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Calculating Opportunity Cost

The way to calculate the opportunity cost is to subtract the value of the option from the value of the alternative that is foregone.

Opportunity Cost = Return on the best foregone alternative - Return on the chosen option.

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It is the estimated value of the best alternative or the best option that one misses out as a consequence of picking one particular option.

Example: Spending a limited resource, like Money, on healthcare, comes with the 'opportunity cost' of being unable to spend that amount on education.

Opportunity Cost in Non-financial Situations

Opportunity cost in non-financial situations is more difficult to quantify. The loss or gain with choosing an option while foregoing another can be subjective and not readily comparable.

Example: While deciding on which job offer to take, we may consider job satisfaction, brand name, commute time, long-term growth, and the salary offered. While finalizing, we have to forego the other best offer. While deciding on a career, we have to consider options like prestige, impact and the work sector.

Opportunity cost calculation is essential to individuals, corporations and governments, where there are decisions to be made regarding limited resources like time, money and effort. Choosing one of the scarce resources always leads to a trade-off in gains.

It is important to account for risks associated with the different available options. Often the rewards that different options offer come with a certain risk.

Many people and organizations fail to take into account the various opportunity costs.

  • We need to actively question ourselves about the alternatives that may be missed out by deciding on a particular option.
  • The often neglected cost of waiting too long is also a decision that can incur a significant amount of opportunity cost, as we lose the time window to take action, losing the better option due to delay and inaction.
  • Not taking an action is also a decision that needs to be evaluated, just like other options.

Certain external constraints make us overestimate the opportunity cost, as we start to imagine all the foregone options as a missed opportunity and start to see the situation irrationally. This can cause a negative emotional and psychological reaction, like regret.

The opportunity cost in these cases should not be viewed as the sum of all your skipped alternatives, but only the value of the best one which is foregone.

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It's easy to overlook the cost of hypothetical opportunities. But if neglected, opportunity costs will negatively impact your life, career, and relationships.

  • Working on autopilot means you put in the hours and get paid, but you end up with nothing: no important knowledge, experience, or assets. If you want to have a satisfying career, you can't afford this.
  • Missed Return On Investments (ROI). Our time and resources are investments. Ask yourself if you could be spending your time on something more effective.

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Consider the price of drinks at a well-known juice bar: a small (350 ml) size costs $6.10; the medium (450 ml) $7.10; and the large (610 ml) $7.50. The medium is a slightly better value than the small, and the large better still. The medium is designed to be the decoy, steering you to see the biggest drink as the best value for money.

If you buy the biggest, was it because you made a sensible choice, or have you been manipulated to opt for bigger than intended?

  • The Unpredictability of The Market: There is never a guarantee that you will make a profit when you make a sale.
  • Credit Risk: When investing using leverage, the bank owns the property until you have paid the loan in full. If you are unable to pay your installments on time, you risk facing foreclosure.
  • Depreciation: Generally, real estate property will increase in value, but it is not guaranteed.
  • Negative Cash Flow: It is the result of a low occupancy rate due to bad tenants that cause destruction or irregular payments. Property with hidden structural problems could also cause problems.
  • Liquidity Risk: If you need cash quickly, you cannot rely on the money you invested in property. Real estate is a long-term investment.