Evaluating a financial decision often means predicting its possible costs. If you have to make a decision, choosing an option inevitably means missing an opportunity. Analyzing the opportunity cost of each choice can help you find which option is best. Learn how to calculate opportunity cost with these basic methods.
Steps
Method 1 of 3: Part One: Choose Variables
Step 1. Understand that opportunity cost is a relative concept
This means that there must be at least two different choices, which will be compared with each other.
A missed opportunity means that once you have made your choice, you will have to give up the other opportunity. For example, if you have been traveling around the world for a year, you will have had to forgo the salaries of a year of work
Step 2. Make the comparison based on the same unit of measurement
The opportunity cost can be calculated in money, weight or products. Sometimes, it can also be measured with abstract concepts, such as personal happiness or experience, in addition to the original unit of measurement.
Step 3. Choose a similar reference period
Each opportunity should be evaluated using information based on a single time period, such as an hour, day, month, or year.
Method 2 of 3: Part Two: Evaluate Opportunities
Step 1. Analyze the two opportunities to define the reporting period
Write the two different opportunities up in two different columns if you can help with the calculations.
For example, if you are considering going on a trip around the world and working at home for a year
Step 2. Evaluate the first opportunity based on what you would earn if you chose the second opportunity
For example, the opportunity cost of traveling around the world is the value of second choice, that is, working at home
Step 3. Add the costs of the first option that you will not be able to pay by choosing the second option
- Examples of costs you will need to calculate to calculate the opportunity cost of traveling around the world are flights and the salaries you would earn by staying at home and working all year round. In our example, let's assume that living and dining costs would be the same at home or while traveling.
- Adding the opportunity costs of flights and missed wages, we find that the opportunity cost of traveling around the world is $ 35,000 in wages and $ 5,000 in flights. The opportunity cost of a one-year round-the-world trip is $ 40,000.
Step 4. Evaluate the second opportunity in light of the first
In some cases, the value may be in lived experience, a difficult concept to evaluate economically.
Consider the opportunity cost of working a full year, rather than traveling around the world. If you have a $ 20,000 contract to write a book about your trip around the world, then the cost of working would be $ 20,000, plus a start to your writing career
Step 5. Make your choice based on which opportunity cost will be higher
This may involve examining concrete things or considering the subjective and personal value of abstract concepts such as, for example, a career as a writer.
Method 3 of 3: Part Three: Cost-Opportunity Examples
Step 1. Look at an example of opportunity cost of a manufacturing facility
The opportunity cost is often calculated as a lost contribution margin if part of the production plant is not used.
Imagine you have two machinery installations in this manufacturing facility. A car breaks down, costing $ 100 per hour in wages and energy when running. The production value is $ 500 per hour. The opportunity cost for each machine is $ 400 per hour. Now you can quickly estimate the value of repairing your machine based on the opportunity cost per day of downtime. For an eight-hour day, that would amount to $ 3,200 in lost revenue
Step 2. Take into account the cost of employee training
Your two choices are: on the one hand a course of. training that will increase the productivity of your employees, on the other hand, let them continue working as usual.
- Calculate the opportunity cost of half a day (4 hours) of professional training, if you are forced to replace staff during those hours. Multiply the hourly stipulation of a single employee by the number of training hours. For example, if your hourly wage is $ 15, then multiply 15 by 4. Now multiply $ 60 by the number of employees you need to replace. If you need two people, then the training opportunity cost will be $ 120, or $ 60 per employee.
- Calculate the cost of choosing not to resort to training. Ask the instructor what he feels is the added value for each employee of the training. If the instructor assumes that you could earn an extra $ 50,000 a year by training two employees, divide the total earnings by the number of working days (261). The opportunity cost would be $ 50,000 / 261 of added value, or $ 191.57 per day for the two employees and $ 95.78 for the single employee.
Things You Will Need
- Paper
- Pen
- Calculator
- Two opportunities
