Almost every day, we make money management decisions. Should I buy lunch today or make lunch at home? Where are the best deals for hockey game tickets? What time of the year are the cheapest flights to Europe? Every case involves looking at a list of alternatives and deciding which alternative is better over the other. We consider which alternatives have its benefits outweighing its costs.
Money management and finance related decisions always involve looking at the benefit of making one decision over another, as well as the costs. Opportunity costs, in addition to actual incurred costs, must be considered in order to ensure you are making a sound decision when it comes to how you spend your money.
Opportunity cost is the cost (or lost income) of pursuing one option over another, or a different option from the one currently practiced. This can be seen all the time amongst ordinary consumers deciding which product to buy, which investments to take part in, as well as at management levels for internal reporting and decision making.
Cost accounting is used for internal management decision making all the time because it considers the opportunity cost of one management decision over the other. How much more money will we make by selling 3000 units of Product B instead of 3000 units of Product A? Do we have capacity to produce extra units on the production floor? Will we be profitable selling extra units above capacity requiring us to outsource some manufacturing elsewhere?
Let's look at an example that many adults will face or have faced:
1) You are planning on going back to school to get another post secondary education which will cost $30,000 over the course of the program. The program is 2 years long. You currently are employed and earn an annual salary of $80,000. Campus is far enough that you will be required to take public transit there or drive. The cost of going back to school over the 2 years would be:
Education cost 2Y Period = (Tuition Fees + Other Education Fees) + Transportation Costs + Opportunity Cost of Not Working
where the opportunity cost of not working would be the annual salary of $80,000.
However, what must also be considered is the bump up in salary and better job opportunities you will get once completed the new degree. These benefits would be the opportunity cost of NOT going back to school and instead continuing to work and earn the $80,000 annual salary. A total cost over say a 10 year period can be considered to get a real sense of the benefit of going back to school:
Cost 10Y Period = Education cost 2Y Period - Predicted Increased Salary and Benefits over 8 years post graduation
We subtract the benefit from the education cost since this is the part of the cost that will be "recovered" over the 10 year time frame. Over a longer period of time, you may find that it's much more worth it to bite the bullet and go back to school for 2 years and miss out on 2 year's worth of salary in exchange for better salary and job opportunities after graduation. This would be reflected in the equation as the increased salary and benefits being greater than the education costs over 2 years ("negative 10Y cost" which translated to a benefit).
Opportunity costs are often over looked and it's important that they are considered in any money management decision. This will ensure that all costs and benefits are transparent for any given "decision tree" so that you can seize the opportunity to make the best possible financial decision for yourself over the short and long term.