How to take into account the real cost of your day-to-day decisions

Should you buy new or used? And that little coffee you often have on your way to work, how much does it really cost?

That’s the kind of question you can answer by taking the opportunity cost, also known as the alternative cost, into account.

Opportunity cost: the unknown variable

You may think that your day-to-day choices have little impact on your personal finances. But every decision, no matter how inconsequential, can leave an imprint on your wallet.

The opportunity cost represents the potential gain you sacrifice by spending your money one way rather than another. There’s a way to calculate it, by weighing the difference between what one decision costs you, and what another decision would cost you.

You can calculate the opportunity cost as follows¹:

• Cost of one option – Cost of the other option = Opportunity cost

Everyday examples

Calculating the opportunity cost is crucial to making an informed decision when making an expense.

For example, if you are in the habit of buying a coffee every time you go to work, the daily expense of, let’s say $3, may seem trivial. But if you calculate its monthly cost, the expense is $60 if you buy one 20 days in a month. Multiply that by 12 months, and you’re looking at $720 a year. Over five years? No less than $3,600.

On the other hand, if you use this money to invest in your group retirement savings plan, for example, you’ll accumulate capital, and generate returns.

That’s how opportunity cost turns a loss into a gain.

Choices that have a signifiant impact

If you do this exercise for each of your financial decisions, you may be in for a few surprises.

Like when you have to choose between financing a major purchase, such as a car, or paying cash for it. If you pay in cash, you give up the opportunity to invest your money and make it grow. However, financing your purchase will require you to pay interest.

The same goes for decisions you must make when you come into an unexpected windfall. A tax refund, for example, can create a dilemma: What do you do with the money? If you choose to spend it on treating yourself, you risk depriving yourself of many things, such as:

• The return on an additional contribution to your group retirement savings plan
• A reduction of the interest to pay on your credit card balance
• The opportunity to top up your emergency fund, so that you don’t have to put an unexpected expense on your credit card, with all the debt and interest that entails

Ultimately, whatever choices you make will always have a financial consequence. Hence the importance of factoring in the opportunity cost.

¹ Business Development Bank of Canada: What is the opportunity cost (alternative cost)?