What is Opportunity Cost?
Have you ever faced life’s most difficult dilemma? What to buy and what to let go? You know the struggle - order take away or save for a wardrobe change. Or worry for more long term problems like credit card debt or student loan EMI. Don’t worry, we totally get it. Prioritizing expenses can be hard, but when done right, it can be beneficial in the long run.
Opportunity Cost meaning - Opportunity cost is the price of the next best thing you could have done had you not made your first choice.
To figure out where to spend is an important decision. We all use an economic theory, without realising it, known as the ‘opportunity cost’. Have you ever found yourself debating ‘Whether I should spend on x or go for y?’ If you spend money on x, then opportunity cost is y, which you had to forego. Let’s take a look at a few opportunity cost examples.
- Watch a movie in a multiplex, or have a meal at a restaurant.
- Take a vacation, or save money to invest in a house.
- Pay off your debts, or buy new assets to generate more profits.
It is worthy to note here that opportunity cost does not always involve money. It can also refer to alternative use of time. For example, spending two hours reading a book, or playing PUBG.
Importance of Opportunity Cost
Opportunity cost is a crucial part of any decision making. The reason is because the resources are scarce and limited. This scarcity of resources compels you to make choices. And with choices come Opportunity Cost.
Let's take a look at the primary reasons why you must consider opportunity cost before making any financial decision.
- Decision making - Opportunity cost helps in making decisions when many alternatives are available.
- Resource allocation - After an analysis of opportunity cost of all the alternatives, you can invest the resources in the right opportunity.
- Price Determination - A comparison of cost involved in the procurement of goods and services with the acquiring alternative options, can help determine the price of the products or services.
Prioritize Your Expenses
We have now established that a choice has to be made when many options are available. This leads you to prioritizing some expenses in favour of others. In other words, make a budget. Now don’t panic with the term budget. It’s not a complicated finance concept we are talking about.
A budget is not just spreadsheets and accounting concepts. You just have to prioritize your expenses. Creating a budget will help you get an idea how much money you have, where you need to spend and where you are actually spending.
How to Prioritize Expenses
You might say, making a budget is easier said than done. We hear you. Prioritizing expenses is a process. When you put your priorities in different categories, that process is broken down and becomes simple. A spending plan can be handy. Keep in mind the following points:
- Identify your expenses: Make a list of your monthly expenses, bills and dues. Understand what is the total amount you are likely to spend in a month. It can have items like:
- Housing
- Grocery
- Utilities
- Transportation
- EMI
- Insurance
- Medical Expenses
- Prioritize your expenses: Identify your needs from wants. Paying for your house is a need so you have a roof. Same is for your grocery. But you can always prioritize what is essential, and what can be avoided. Examine each item from the expenses list, to identify the ‘must pay’ and ‘can be delayed’.
- Cut down your debts: After identifying your ‘must pay’ expenses, prioritize the debts you must pay that can affect your credit, including credit card dues and loan repayment. Missing or delaying your dues can seriously impact your Credit Report (read more link).
Why is Prioritizing Expenses Important?
Just like your time, money too is finite. It’s irrespective how much or how less it is. You have to prioritize where to spend it. We have listed reasons why you must prioritize your expenses, that will change your perspective towards the process.
- Avoids Overspending: Spending money without prioritizing has a great chance of you overspending. Overspending today means debt in the future, as you will end up taking debt for essential payments. In turn, a large part of your income will be used to repay that debt.
- Helps Reach Goals: Prioritizing expenses can help you set up a goal, like buy a house or go for your dream vacation. Set aside money each month and come closer to your dream every month.
- Helps Save Money: When you prioritize, you eliminate the non-essential. The surplus money can always go into saving as an emergency fund.
- Allows Flexibility: Once you have set aside the savings fund, you can always alter your priority list of expenses. The ‘must pay’ and ‘can be delayed’ is up to you to change.
- Reduces Your Worries: Prioritizing is making a choice, where to spend and how much to spend. You allocate the money between expenses and savings. Definitely saves you from worrying about the rainy day.
- You are the master: You decide where your money is spent. You can control the overspending. It is the biggest tool to work towards your financial future.
- It’s simple: Prioritizing or budgeting is a process, and breaking it down can simplify the process. You’ll get a hang of it with time.
Earning money is not sufficient. Managing it effectively is equally vital. Carefully examine every opportunity and then prioritize the expenses. It will go a long way to manage and grow your finances.
