When we’re faced with a decision there can be overwhelming feelings due to how many paths life could lead. In the modern world there are just so many decisions placed on us daily that it can hard to even know what the right path forward is. Opportunity cost is a practice that can help us make more level headed decisions. It takes into account all of the potential outcomes of a decision and allows us to rationally see what is the best option.
So What Exactly Is Opportunity Cost?
The opportunity cost of a decision is the value of the best forgone alternative. In other words, it’s what you give up when you make a choice. Lets begin with a real world example to try and explain this better.
Let’s say you have $100 and can either spend it on a new phone or a new pair of shoes. The opportunity cost of buying the new phone would be the new shoes you could have bought instead. This is because your $100 only allowed you to buy one of the two things, not both. The opportunity cost is what you forfeit when you make a decision.
Investment Opportunity Costs
For many business opportunity cost is a truly relative analysis that can help to determine the right steps for the organisation. A company might have two departments that are both vying for a larger slice of the budget. The opportunity cost analysis can help to show which department’s investment will have the greater return. Often, managers will use sunk cost fallacy when making decisions. This is where they assume that since they have already invested so much into one department that they must continue with this regardless. However, opportunity cost analysis can show that the other department may have been a better investment from the start. There is another fantastic opportunity cost write up available at Investopedia.
So How Do We Calculate This Opportunity Cost?
When using these ideas its important to understand they have real world formulas which you can apply to many situations. The value at the end may be considered in a few components like satisfaction, money and of course time. Some basic formulas for understanding opportunity cost include.
Opportunity Cost = What You Have Given Up / What You Have Gained
or
Opportunity Cost = Total Revenue – Economic Profit
Explaining what economic profit is basically the money the business has made after deducting all costs involved, both implicit and explicit. If there is no future economic profit the business is destined for one thing, failure.
The Life Path We Choose Always Has Consequence
Just like the principle of cause and effect, every single action (or cause) we take will eventually have an effect down the path. This is the same for viewing opportunity cost as whatever path we choose to take, there will be repercussions and gains from this. In a business sense it is a bit more practical and analytical as you can focus on the money gained or loss. However in a real life example there is a lot more to consider in this process. Our life paths are not judged by the money we earn and often there are silver linings in all “bad experiences” we endure. This is because of the dualistic nature of reality that we’re living in.
What Is Decision Fatigue And How Does It Relate?
Decision fatigue is a more new age phenomena that is being researched more and more. Decision fatigue is the idea that as we’re making choices, the longer in duration and the more choices we need to make the less accurate we will be in determining the correct decision. Decision fatigue occurs when the mental exhaustion settles in and we have too much decision to make.1 This is why applying the knowledge of opportunity cost is an easy format to replicate when making deciding on action has become less clear.
What Does Research Say About Decision Making?
There is a study that was completed recently that helped to shed some light on the best way to make decisions based on 140 applicants. Basically the participants had to select between three different foods and they found basically the best choices to be those who focused on the best two choices rather than one.2 The less time we have to focus on the decision and instead break it down into bite sized chunks of thinking helps to offset any irrational decisions.
So Concluding Opportunity Cost
Opportunity cost is important to understand as it can help to save or make us money. It also helps to focus on what we value most in our lives. What we value is relative to each individual but by utilizing opportunity cost in our decision making it can help to better reflect those values.
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