Opportunity Cost: The Missing Variable
What is the first thing that almost any personal finance blogger that tends to align themselves in “Camp Frugal” will tell you when it comes to saving money? Most likely it is a variation of the mantra, “Spend less! Save, save, save! Quit spending money!” Is this really the best way? It seems that many people, myself included, can leave an important variable out of the cost saving and wealth maximizing formula. This “missing variable” is opportunity cost.
Opportunity Cost Explained
What exactly is opportunity cost? Let’s say that you have two different things that you could do with an hour of your time: Activity A or Activity B. You can only choose one of them but not both. If you choose to do Activity A then you cannot do Activity B and vice versa. If Activity A is your #1 choice for what you would choose to do for that particular hour and Activity B is your #2 choice then when you choose to do Activity A, and are therefore excluded from doing Activity B as well because remember you can only choose one or the other, your opportunity cost is the cost to you in not being able to partake in Activity B.
The technical definition of opportunity cost is therefore the cost of the next best alternative (the thing that you have given up) whenever you are making a decision between two or more mutually exclusive choices.
It’s important to remember that opportunity cost is not necessarily always measured in financial terms (although it is a smart thing to do to ultimately convert all opportunity costs into a financial measurement so that you can better compare options).
Let’s take a look at some different scenarios to see if strictly adhering to the “Spend Less” rule in all circumstances is the best way to go or if there are times when taking a closer look at the opportunity costs involved might help us to improve upon our cost savings and wealth maximizing “formula” and ultimately create wealth and skyrocket our net worth even faster.
Calculating the Value of Your Time
If you are a fan of the 4 Hour Work Week by Timothy Ferris then you no doubt are familiar with the idea of calculating just how much your time is worth to you. The short version of this process is to simply find out how much each hour of your time is worth to you using cold hard dollars and cents and then use that number to make everyday decisions.
Mowing the Grass vs. Paying Someone to Mow Your Grass
Let’s say that you calculate that your time is worth $50/hr working on your side business/doing freelance work/picking up some overtime/etc. and you have a decision to make when you get home: you can either spend an hour of your time when you get home doing one more hour of work or you can spend an hour mowing the lawn.
If we assume that there is no other positive utility to you mowing the lawn because you enjoy mowing the lawn, you enjoy being outside, you find it relaxing, etc. then let’s say that it costs you $25 to have someone come and mow your lawn for you. You can either mow your lawn yourself or you can pay someone else to mow your lawn for you and work one more hour on your own business/freelance work/overtime. What should you do?
Everyone in “Camp Frugal” would likely say, “Save money! It’s a waste of money to pay someone else to mow your lawn for you! Cut back on expenses – do it yourself!” However, given the above scenario if you chose to mow your lawn yourself you would be losing out on $25 after you factor in the opportunity cost and the value of your time. If you take an hour of your time to mow the lawn yourself then you spend nothing and earn nothing (your gain = $0). If you pay someone $25 to mow your lawn for you and you use that hour to work for yourself and earn the value of one hour of your time at $50 then you spend $25 and earn $50 (your gain = $25).
“Camp Frugal” Could be Costing You Money
If you strictly follow the advice of “Camp Frugal” that says to cut costs in every area possible without first taking into account the value of your time and the opportunity cost of the various choices that you have to make then you very well could be losing out on quite a large sum of money in the aggregate when you total up the many different scenarios similar to the mowing the lawn scenario above.
Of course, the value of everyone’s time is different as I have heard it said before that if you calculated exactly how much Bill Gates’ time is worth then he would actually be losing money if he saw a $100 bill on the street and he paused 5 seconds to bend over and pick it up!
Granted, neither you nor I can claim to have time as valuable as Bill Gates but have you bothered to calculate how much YOUR time is worth?
If you do the calculation and find out that your time is not very valuable then what things can you do to increase the value of your time?
What other common scenarios similar to the “lawn mowing” scenario do YOU have where opportunity cost is involved but often overlooked?
Author Bio: Joel is a CFP® and a serial entrepreneur that loves working on various Internet based projects. Some of his most recent ventures include various consumer comparison financial websites including websites for finding life insurance, comparing car insurance companies, and researching credit card offers. He is a newcomer to Fortune Watch and one of his favorite recent posts by Robin is the post titled, “Don’t Rush to Pay Down That Mortgage” as it talks about opportunity cost and some of the other things mentioned in the post below. Can be contacted on joeljonathanohman at gmail dot com
Thanks! – Joel