Periodic Opportunity Cost
Is there a nonessential item or service you simply can’t resist spending money on? This calculator will tell you the true opportunity costs of your frivolous expenditures.
Let’s say you spend $4 every day on a latte. Enter that amount in the provided field, followed by how often this purchase recurs. Then enter an interest rate that this amount of money could be earning if deposited into a bond or CD investment (let’s say 5%). Then enter a number of years for which you would like to calculate your opportunity costs. For the sake of this calculation, we’ll say 10 years.
Press CALCULATE, and the true cost of your spending becomes obvious. On lattes alone, you will spend $14,592. If you had put that money into a savings account, you could have made $4,290.33 in interest alone. This means that your opportunity costs for this expenditure amount to a whopping $18,882.33!
A few things to consider:
- Forgone interest is compounded monthly and forgone purchases are invested at the end of each spending period.
- Some items may come with additional ownership costs: maintenance, repairs, operating costs (gas, electricity, etc.), insurance, storage, etc.
- The US stock market has averaged a return of nearly 10% over the long run. Investing your savings paying off high interest debt could earn an even better return as income is taxed while interest savings are not.
Understanding the Opportunity Cost of Monthly Expenses
You don't often see a high-powered litigation attorney changing his own oil or a sought-after plastic surgeon mowing the lawn. Perhaps the wealthy opt out of these mundane chores because they are pampered and can afford to pay others to do these services. While that might be the case, the decision also just makes financial sense because of the concept of opportunity cost. Read on to learn what opportunity cost is and how it applies to your spending and saving decisions.
Defining Opportunity Cost
In economics, opportunity cost refers to the most highly valued opportunity you forego when you make a choice. For instance, the opportunity costs of going to Dairy Queen instead of the gym are the calories you would've burned and the health benefits you would've reaped. Likewise, the opportunity cost of buying a car might be foregoing your yearly beach vacation.
Consider an example of opportunity cost. Assume that an attorney commands a rate of $500/hour and that changing his own oil would take three hours (while he's a whiz at jurisprudence, just finding the oil dipstick will present a challenge). Also assume he could take his Mercedes to the local quick-lube shop and have the oil changed in 20 minutes for $40. If the attorney changes his own oil, he loses three billable hours during which he would've earned $1,500.
On the other hand, if he outsources the task it only costs him $207 ($40 plus $167 in billable hours). If he washes his hands of the task completely and has his personal assistant, who makes $20 per hour, do it, he saves even more: An oil change would only cost him $47 ($40 plus $7 in wages). Doing the math on the opportunity cost sheds some light on why top earners usually delegate tasks like this.
Applications to Personal Finance
Applied to personal finance, the concept of opportunity cost helps delineate the benefits and costs of saving versus spending. Every time you indulge an impulse to spend, you reap a benefit and an opportunity cost. The benefit is the immediate gratification of being able to use or consume the good or service you bought. The opportunity cost is that you now have less money to buy products and services in the future.
By contrast, the opportunity cost of saving is that you must delay gratification and not buy as many goods or services. The benefit, however, is that saving will enable you to buy even more of what you want in the future.
The Opportunity Cost of Frivolous Spending
Opportunity cost can also help you understand the perils of frivolous spending. While simple luxuries like that daily caramel Frappuccino might seem small, the long-term opportunity cost of those delicious coffee drinks amounts to thousands of dollars. Let's assume you spend $5 on coffee every weekday for 50 weeks out of the year. That means you spend $25 per week on coffee for an annual opportunity cost of $1,250.
Even if you decided to spend those savings at the end of the year instead of investing them, that amount is enough for a Caribbean cruise for two. Consider the annual opportunity costs of a few other frivolous spending habits:
- Spending $1.25 on soda every day amounts to an annual cost of $325. Just cutting back to $0.45/day would save you $208 per year.
- Spending $5.25 every day on a pack of cigarettes translates to $1,916.25 annually.
- A monthly cable bill of $86 amounts to $5,160 over five years. That's enough for a down payment on a car or almost three semesters of community college.
Saving and Investing vs. Spending
The opportunity costs of frivolous purchases mentioned so far don't even account for the additional opportunity cost of the money you may have earned in interest if you had saved instead of spent. Even at the extremely small interest rates of regular savings or money market accounts, you can still grow your wealth considerably over time. For example, let's say you quit smoking and instead put the money in an interest-bearing savings account with a yield of 1.0 percent that compounds monthly. At the end of five years, in addition to better health, you would have $9,840.90.
Opportunity cost clearly illustrates what you're giving up by giving in to frivolous spending. That $5.25 per day on a pack of cigarettes may seem like a pittance in the moment, but quantifying the opportunity cost shows you just how much you're forsaking for that momentary comfort. Keeping this principle in mind can help motivate you to trim the fat in your budget and sacrifice more now to reap the benefits later.