No matter your income, it is important to understand the concept of Opportunity Cost. The official definition is “the loss of potential gain from other alternatives when one alternative is chosen.” It is also “what you must forgo in order to get something”. The concept can help a family, regardless of their income, build wealth, save money, increase their income, decide whether to work or not, where to spend their time, and there are other benefits.
What exactly does this mean? It may be best if we provide some examples of what Opportunity Cost is. Maybe the most relevant example for readers of this blog is the cost of daycare vs. working. Another one is where you focus your work time on.
Daycare is one example I have talked about in the past with some people. Lets say one parent of a two income household decides to place their kid(s) into day care so they can work and it costs them $18,000 per year to pay for the child care. They make this decision so they can go to work and make some money, so the Opportunity Cost here is giving up (forgoing) time with the kid (as they will be in daycare) in order to “get more money in the bank”. Lets say the income that the parent who goes to work is $45,000 per year, pre-tax.
Now most people may be like I am making 45K per year and paying 18K per year in daycare. They may not be happy with this fact, but they still think they are coming out ahead by 27K. But that is not the case, and this leads into really thinking about the math around Opportunity Cost. A few things to consider.
- -Their total take home pay is not 45K. Maybe they take home (after tax) $37,000 per year, but of course the exact after tax income pay will depend on their tax bracket.
- Then they need to take into all the extra expenses that come with working. Examples may be work clothes, added transportation/commuting costs (maybe a second car, etc.), additional food costs such as occasional lunches out, maybe they have less time to cook dinner so more take out or restaurant meals for dinner and eat less healthy, etc. Now who knows what those extra costs may total, but it is more likely to be in the thousands of dollars vs. hundreds, especially when it comes to car(s) or transportation.
Taking all this into account, if the after tax income is 37K and then (using a random number to account for extra expenses) lets say those extra costs for working are 5K. Now the working parent is netting 32K. So what is the opportunity cost?
After the 32K in income, minus 18K in day care, the total net income is 14K, and the working parent is only bringing home that much. The opportunity cost for that is they are not seeing their kid(s) as the child is in day care (which of course has pros and cons). Is it better for the parent to stay home with the kid(s) then bring home an extra 14K per year? Or maybe they could get a small work from home job say in the evening (and keep the kid home in the day) to close that gap? Everyone needs to make this decision on opportunity cost, and what they will give up vs. gain. But they really need to think about (and know) the math around it before making that decision.
Hiring someone to do a project vs doing it yourself will also have an opportunity cost. Lets say you make $300 per hour as a consultant and you need to have some work done on your home, such as painting. If the home project costs $1200, but it would you 6 hours to do it yourself (at $300 per hour of lost income or $1800 total), the cost for you to do the job is $600. So you are actually losing money by doing the work yourself! This is the difference between their lost income ($1800) vs hiring some to do the work ($1200).
Spending money on a want (such as vacation or some “label” brand of clothing), the opportunity cost (what you forego) may be the benefit of saving and investing that money, which can build wealth over time vs. the short term gain of a vacation. Or giving up the ability to save/invest in order to get some label on an article of clothing that really no one cares about and is really about your own insecurity.
If you want to build or currently run a successful business, the opportunity cost is giving up any time spent on that business to pursue other opportunities. As the time spent away from your core strength/business has a cost involved in that too. For example, if you are starting or in the midst of building a business for mid to long term financial stability, and you decide to sleep, waste time on a mindless activity, not discipline yourself, not get help from experts, etc. there are opportunity costs for those decisions, and I try to always tell people I mentor this. Keep you eye on the ball, even when it gets challenging or frustrating, and if you do not do that, then you opportunity cost is in some ways “given up”. This is one of the huge benefits to specializing, focusing, and discipline….keep you eye on the mid to long term goal.
Millions of workers eat lunch out every day, or maybe spend money on a breakfast on the way to work or pick up food after work. That cost adds up, and there is an opportunity cost for that. Lets say you spend on average $12 per day on one or more of those activities. With ~240 workdays per year, that is ~$3000 per year. Some people may be like it is worth it to eat out or grab a quick bite, and say they can afford the 3K, so what is the big deal?
But what is the opportunity cost there? Lets say you do that for only “20 years” during your work life. Now of course that $12 per day you spend now will need to increase due to inflation. The opportunity cost, or loss of future investments, do eat out like we noted above is $150,000 to $250,000 over 20 years. And that is only after 20 years…most people work more years than that.
You may ask how is that!? Well, if you invested that $12+ per day instead and “only” received 7% per year on it from stocks, that money would grow to $150,00 to $250,000 over 20 years due to the magic of compounding. Luckily I realized this compounding effect at an early age (in my teens) so I was able to invest in stocks and other investments back then which is one key to my financial freedom. i was investing as a teenager, in college, etc., and I tell you it was great to see my money work for me. I was making more in dividends and investment income (in addition to working throughout my school years) that I reinvested that allowed me to retire early.
Those are a few examples of opportunity cost. In order to build wealth, make the best use of your time, and make important life decisions, we always recommend to think about what you are giving up in order to get something. And when it comes to dollar and cents (such as daycare), you need to literally do the math to determine the Opportunity Cost.