What is opportunity cost?
Let’s shed some light on the obscure concept of opportunity cost…
Two years into her career, my wife decided to start a management degree. Not an MBA but something similar. Management degrees are expensive but they cost way more than the price tag, because of opportunity cost.
I would like to explore this concept of opportunity cost with you today.
Back to the story, my wife decided that studying and working full time would be too much so she asked her employer to let her work 3 days a week. The employer refused. So my wife found another job where she could work three days a week. But she had to take a pay cut in addition to the lower part-time salary. All in all, she earned about 50k less than if she would have stayed at her previous job working full time.
If she would have stayed at her previous job working full time – That’s our baseline scenario. When calculating opportunity cost, it’s important to define exactly in comparison to what alternative this cost is calculated. Opportunity cost is how much money you could have gotten but didn’t.
So we could stop there: the total cost of this degree was the registration fee (20k) plus the 50k that she could have earned but didn’t. That’s already 70k and that’s a lot of money. But this approach is too simple.
See, in the baseline scenario, she wouldn’t have kept the 50k because taxes would have taken a good chunk of it. At a marginal tax rate of 30%, she would have kept all in all 35k. 35 plus 20 makes 55. Still expensive but less painful… Unfortunately, that’s not the full story yet.
In the baseline scenario, my wife would have not only kept the 35k but we would have invested it in the stock market. We would also have invested the 20k registration fee.
Since the year she did her degree was 2017, we have to calculate how much those 55k, invested in 2017, would have turned into today. The stock market essentially doubled since then. So those 55k be 110k today. Ouch… That’s one expensive degree. And every year the value of stock market climbs, that cost increases!
That’s the issue with opportunity cost: it usually grows with time. Think about it: what is the opportunity cost for your family of your grand-father buying a Volvo instead of a Ford 50 years ago? Well, that’s the difference in price (let’s say 10k) compounded at 7% for 50 years or… around 300k! That’s serious money.
Opportunity cost is often neglected when considering big life decisions. Obviously, money shouldn’t be the only factor in the decision making but accounting properly for opportunity cost helps to make more informed decisions.
For instance, when I took my 9 months sabbatical, I was well-aware that it was costing me about 90k in salary. And every year, that money that I didn’t earn and didn’t invest and that is currently not compounding increases. 30 years from now (projecting 7% growth), those 90k will be just short of 700k. But for our family, is was well worth it, because money is not the only factor.
For my wife, doing this degree was also well worth it. Personally speaking, she is much more fulfilled in her current job as a manager than she would have been as an engineer. But financially speaking as well: she now earns more money than in the baseline scenario, so she is slowly working her way to getting even. And since she will be working another 30 years, it will be a net win in the end.
So here is the method to determine opportunity cost of a decision:
- Define the baseline scenario: how much would earn, keep after taxes, and invest if you didn’t make the decision?
- Same thing in the case you made the decision
- Compute the difference and compound it at 7% per year
What is the life decision that had the highest opportunity cost for you but that you don’t regret making? Let me know!