Every choice that you make has consequences (financial or otherwise).
If you choose apple pie over a brownie a la mode for dessert, you not only get the apple pie, but you give up the opportunity of having the brownie a la mode (unless you eat both, but we would never <wink, wink=””> do a thing like that). The act of choosing one alternative means you’ve given up the benefit you could have had if you had chosen a different option.</wink,>
What is opportunity cost and how is it calculated?
Opportunity cost is the benefit given up by choosing one alternative over another. In matters involving purchasing decisions, the opportunity cost of choosing a more expensive option is the difference between the return from the option passed up (i.e., the return you could have had if you had chosen the less expensive option) and the return from the option selected (i.e., the return you get from choosing the more expensive option). In most cases, the return from the more expensive option is zero (assuming the item chosen is not an appreciating asset), so the opportunity cost can be measured by the return from the option passed up (the lost benefit, i.e., the earnings from investing the cost savings if the less expensive option had been chosen).
If you choose to buy a new car for $25,000 instead of buying a used car for $12,000, the cost of the new car (the “sunk cost“) is $25K. If you go for the used car, the cost savings is $13K. But what is the opportunity cost of buying the new car instead of buying the used car, assuming that you would take the cost savings and invest it in the market while you own the car and beyond? (This example assumes you pay cash instead of financing either car purchase, the gas mileage and maintenance are the same, and you keep both cars for 7 years.)
Assuming an average return rate of 10%, the $13K savings would grow to more than $26K compounded monthly for 7 years (more than enough to buy a second new car in cash). If you never spend the initial savings and keep it invested longer, the $13K would grow to $57.9K after 15 years and $257.9K after 30 years. (There would be a higher residual value for the new car after 7 years, but the difference would probably not be significant enough to materially change the result.) Under these assumptions, if you just look at a 7-year time frame, the opportunity cost of buying the new car would be $26K. If you assume that the cost savings would remain invested for longer periods of time, the opportunity cost would be even greater (nearly $58K after 15 years and $258K after 30 years). You’d have to really have liked that new car to make that cost “worth” it.
What does opportunity cost have to do with personal finance and what do we mean by ‘invest the difference?
Every purchasing decision you make has a cost. When you are faced with more than one option, the cost differential (cost savings) is simply the out-of-pocket difference between the two (or more) choices. It is also useful to analyze the opportunity cost of choosing one option over another. This can be done by estimating how much you could potentially earn by investing the difference (investing the cost savings) between the two options.
You can apply the “Invest the Difference” concept to large expenses such as:
- buying a car (new vs. used)
- renting an apartment (spending more vs. spending less on rent)
- buying a house (although any opportunity cost calculation would have to factor in differences in appreciation, maintenance, taxes, etc.)
…as well as to regular everyday purchases like:
In each case, the opportunity cost of choosing one alternative over the other would entail figuring out how much you could earn if you invest the difference in cost between the two options.
Otterwize has a number of posts with “Invest the Difference” examples that illustrate how much you could potentially earn/save by switching from one choice to another choice and investing the difference (investing your regular, periodic cost savings) over time. (See “Switch from This to That and Invest the Difference“; “Watching Your Money Go Up in Smoke“; “The $200,000 Cheeseburger“; and “How Saving $5.25 a Day Could Turn a 25-Year-Old Into a Millionaire.”) Simple changes implemented over the long term—like using filtered tap water instead of bottled water or bringing lunch to work instead of buying lunch—can potentially add up to large amounts if you regularly invest the savings (invest the difference), subject, of course, to market conditions.
The bottom line: When you are analyzing the cost of purchasing one item instead of another (or choosing one course of action over another), don’t just look at the actual price tag of one vs. the actual price tag of the other. Consider also the opportunity cost of your decision by figuring out how much you could potentially earn if you choose the less expensive option and invest the difference (invest the cost savings). The raw savings are important at the time of purchase, but the actual difference to your wallet over a longer period of time can be found by looking at the opportunity cost of choosing one option over another.
If you consider the power of compounding and make strategic choices in your everyday spending habits as well as big-ticket one-time purchases, you can potentially save and earn large amounts over the long term by choosing wisely among alternatives and investing the difference.