making a choice

Opportunity costs apply to every single financial decision we ever make, yet very few of us understand the concept well enough to make the most of our cash. However, as always, some valuable lessons can be gleaned from a look at the way big businesses operate.

What is an ‘Opportunity Cost’

Very simply, an ‘opportunity cost’ is what you miss out on when you choose to do one thing over another. For example, if you spend £20 on a night out, you miss out on the benefit of putting that £20 into a savings account.

So, whenever you buy a product or a service you are in fact faced with two costs; the price of the product/service and the ‘opportunity cost’ of not being able to use that money for anything else.

How Do Businesses Use Opportunity Cost?

Businesses (successful ones at least!) always attempt to plan as far ahead as possible. They use the idea of opportunity cost to help them decide how to spend their money in the way that will be most beneficial to the business in the long term. They do this by thinking about the ongoing consequences of their opportunity costs.

For example, a relatively new independent clothing shop, which has gained popularity and started to turn a profit may need to decide if is going to invest that profit in spending on advertising to drive up demand, or in a new member of staff, to deal with their current demand better.

They can only pick one, but they need to consider the ongoing consequences carefully. For example, spending more on advertising, driving up demand and making more profit sounds great, but the opportunity cost of not hiring a new employee may mean that the shop is under staffed.

If the business can’t cope with the higher demand, it may lead to a worse service and a worse reputation. Not a good result considering that the company choose to spend their money on spreading their name!

Just as the cost of hiring an employee would be ongoing, the cost of being constantly understaffed is also ongoing. In fact, it is likely to get worse as time goes on. So, although a lot of the time weighing up opportunity costs will lead a business to spend money on whatever is most urgently needed (just as a individual would), businesses are usually a lot better at judging how the opportunity cost of a decision may change over time.

Furthermore businesses understand that, in the same way the opportunity cost of a financial decision can change over a period of time, so can the value of the money involved.

The Time Value of Money

When calculating opportunity costs businesses will always consider ‘the time value’ of the money involved, something many of us wouldn’t think to do for one simple reason; we don’t know what the ‘time value’ of money is!

Thankfully, this idea is also simple. If you put £100 in a savings account at 5% interest per annum, in one year you’ll have £105. So, if you spend £100, the opportunity cost is not limited merely not having £100 anymore, it also includes missing out on the £105 ‘future value’ of the money.

As businesses are always looking for a good return on investment, they expect any money they spend to make more money for them in the future. Sadly, this is the opposite of the way we consumers tend to think about our own spending.

How Can I Use These Ideas to Improve My Personal Finances?

In practical terms we are all aware of how opportunity costs work. Even the child in the sweet shop is aware of the opportunity cost involved in including a heavy piece of fudge in his bag of pick and mix, rather than several light marshmallows.

Weighing up the opportunity cost of your day to day spending is obviously a good way of stopping your wages being drained away by unwise purchases. If you constantly have an eye on the alternatives, you’ll be less likely to be seduced by any old offer put in front of you.

However, when we look at the way businesses operate we realise that the real value of understanding opportunity costs lies in the way it will help you look ahead when making a long term financial decision.

For example, if you were going to spend £10,000 on a car, at first it would appear that the opportunity cost of such a decision would be no longer having that £10,000 available to spend on other things. But, if you think like a business, you’ll take both the ongoing nature of opportunity costs, as well the time value of money, into account. When you do this, you soon realise that, if you take a longer view, perhaps three years or so, the opportunity cost is quite different.

That £10,000 could have been placed in a high interest savings account earning 7% per annum. The car, on the other hand, will have depreciated by maybe 60% in the same amount of time. So, in three years time you end with a car worth £4,000 when you could have had £12,250 in your savings account. The savings soon worth three times more than the car.

(Obviously, this is just an example and you should remember that going with the savings account instead of the car would have its own opportunity costs.)

The lesson here isn’t that you should never buy anything that will depreciate. Nor is it that you should save everything you earn! However, you should use opportunity costs to look ahead and think about the long term implications of your spending.