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What is the Opportunity Cost of a Decision?
Opportunity cost is one of the key concepts in the study of economics Economics CFI’s Economics Articles are designed as self-study guides to learn economics at your own pace. Browse hundreds of articles on economics and the most important concepts such as the business cycle, GDP formula, consumer surplus, economies of scale, economic value added, supply and demand, equilibrium, and more and is prevalent throughout various decision-making processes. The opportunity cost is the value of the next best alternative foregone. In simplified terms, it is the cost of what else one could have chosen to do.
Considering Alternative Decisions
Principles of management accounting Financial Accounting Theory Financial Accounting Theory explains the “why” behind accounting – the reasons why transactions are reported in certain ways. This guide will help you understand the main principles behind Financial Accounting Theory or corporate finance Corporate Finance Overview Corporate finance deals with the capital structure of a corporation, including its funding and the actions that management takes to increase the value of dictate that opportunity costs arise in the presence of a choice. If there appears to be only one option presented in the decision-making process, the default alternative is laissez-faire (to do nothing) with an associated cost of zero. However, if a decision maker must choose between Decision A or B, the opportunity cost of Decision A is the net benefit of Decision B and vice versa.
How is Opportunity Cost Calculated?
In financial analysis, the opportunity cost is factored into the present when calculating the Net Present Value formula NPV Formula A guide to the NPV formula in Excel when performing financial analysis. It’s important to understand exactly how the NPV formula works in Excel and the math behind it. NPV = F / [ (1 + r)^n ] where, PV = Present Value, F = Future payment (cash flow), r = Discount rate, n = the number of periods in the future .
NPV: Net Present Value
FCF: Free cash flow
r: Discount rate
n: Number of periods
When presented with mutually exclusive options, the decision-making rule is to choose the project with the highest NPV. However, if the alternative project gives a single and immediate benefit, the opportunity costs can be added to the total costs incurred in C0. As a result, the decision rule then changes from choosing the project with the highest NPV into undertaking the project if NPV is greater than zero.
Financial analysts use financial modeling What is Financial Modeling Financial modeling is performed in Excel to forecast a company’s financial performance. Overview of what is financial modeling, how & why to build a model. to evaluate the opportunity cost of alternative investments. By building a DCF model DCF Model Training Free Guide A DCF model is a specific type of financial model used to value a business. The model is simply a forecast of a company’s unlevered free cash flow in Excel, the analyst is able to compare different projects and assess which is most attractive.
Application of Opportunity Cost
For example, assume a firm discovered oil in one of its lands. A land surveyor determines that the land can be sold at a price of $40 billion. A consultant determines that extracting the oil will generate an operating revenue of $80 billion in present value terms if the firm is willing to invest $30 billion today. The accounting profit would be to invest the $30 billion to receive $80 billion, hence leading to an accounting profit of $50 billion. However, the economic profit for choosing to extract will be $10 billion because the opportunity cost of not selling the land will be $40 billion.
Other Costs in Decision-Making: Incremental Costs
A firm may choose to sell a product in its current state or process it further in hopes of generating additional revenue. For example, crude oil can be sold at $40.73 per barrel. Kerosene, a product of refining crude, would sell for $55.47 per kilolitre. While the price of kerosene is more attractive than crude, the firm must determine its profitability by considering the incremental costs required to refine crude oil into kerosene.
In this example, the firm will be indifferent to selling its product in either raw or processed form. However, if the distillation cost is less than $14.74 per barrel, the firm will profit from selling the processed product. If not, it would be better to sell the product in its raw form.
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Other Costs in Decision-Making: Sunk Cost
A sunk cost is a cost that has occurred and cannot be changed by present or future decisions. As such, it is important that this cost is ignored in the decision-making process.
For instance, assume that the firm described above has invested $30 billion to start its operations. However, a fall in demand for oil products has led to a foreseeable revenue of $50 billion. As such, the profit from this project will lead to a net value of $20 billion. Alternatively, the firm can still sell the land for $40 billion.
The decision in this situation would be to continue production as the $50 billion in expected revenue is still greater than the $40 billion received from selling the land. The $30 billion initial investment has already been made and will not be altered in either choice.
To learn more and continue advancing your career, see the following free CFI resources:
- Cost Behavior Analysis Cost Behavior Analysis Cost behavior analysis refers to management’s attempt to understand how operating costs change in relation to a change in an organization’s level of activity. These costs may include direct materials, direct labor, and overhead costs that are incurred from developing a product.
- Activity-Based Costing Activity-Based Costing Activity-based costing is a more specific way of allocating overhead costs based on “activities” that actually contribute to overhead costs. An activity is an event, task, or unit of work with a specific purpose, whether it be designing products, setting up machines, operating machines, or distributing products.
- WACC Formula WACC WACC is a firm’s Weighted Average Cost of Capital and represents its blended cost of capital including equity and debt. The WACC formula is = (E/V x Re) + ((D/V x Rd) x (1-T)). This guide will provide an overview of what it is, why its used, how to calculate it, and also provides a downloadable WACC calculator
- Types of Financial Models Types of Financial Models The most common types of financial models include: 3 statement model, DCF model, M&A model, LBO model, budget model. Discover the top 10 types
What Is Opportunity Cost and What Does It Mean for You?
Jul 31, 2020 2:38 PM EDT
Opportunity cost is largely defined as a decision you make that alters your personal landscape going forward.
Opportunity costs can impact various – and critical – aspects of your life, including money, career, home and family, and other lifestyle elements. In general, it means having to choose one option over the other, be it money, time or lifestyle choices – and living with the consequences.
If you are a business owner, opportunity cost is going to come into play frequently. You will have to spend a lot of time weighing whether or not the inevitable consequences of a given decision are outweighed by the gains that decision will bring. And whether business or personal, opportunity cost will often be a tangible figure.
To gain a different perspective on opportunity cost, ask yourself this question: What scenarios can occur if I opt for one path over another? What’s more, what outcome am I leaving on the table and how is that my opportunity cost?
Explicit vs. Implicit Opportunity Costs
Economists break down opportunity costs in two ways – via “explicit” and “implicit” opportunity costs.
Explicit opportunity costs
An explicit cost is, as one would imply, a cost that is explicitly shown in your accounting records. It’s a cost that will be reflected somewhere in the income statement.
Let’s say you own a landscaping company and you add several brand-new lawn mowers to your business for $3,000. In that regard, your explicit opportunity cost is any alternative use of that $3,000. The cash could have been used to place more advertising in your community, to upgrade your company’s website, or as a down payment on a new truck for your company. What outcome results from your decision to buy those lawn mowers over other business options is the manifestation of your opportunity cost.
Implicit opportunity costs
With implicit opportunity costs, the formula is moderately different, primarily because there is no direct accounting cost stemming from implicit opportunity cost (i.e., you chose to spend $3,000 on lawn mowers over a down payment for a new truck for your company.) Consider a small business owner who foregoes a salary, even though the business owner’s substantial business skills and acumen are integral to the success of her business. By electing not to take a salary, that business owner’s unpaid salary is an implicit business cost. By foregoing a salary, the business owner is taking financial pressure off the company and boosting its chances for success at a critical stage (i.e., the launch of a business when money is tight and extra cash is critical). Here, the business owner is making an implicit cost decision for the long-range health of her company.
In both examples, the landscaping company owner and the small business entrepreneur are leveraging opportunity costs in positive ways – they’re making choices fully cognizant that the decisions they’re making do have real-world consequences.
Yet the research, study, and due diligence they bring to their decision-making processes increase the likelihood that they’re making the right kind of opportunity cost decisions.
Opportunity Cost Examples
The examples of opportunity costs in business are fairly self-explanatory. Buying new machinery for your factory has a clear explicit cost. A small business owner declining an annual salary is a clear implicit cost. But what are some of the ways opportunity cost can pop up in and impact your individual life?
Opportunity costs start fairly early in life. What if you choose to go to college, or opt to learn a trade? Or, if you go to college, which major do you choose? And if you opt to learn a trade, what happens if you choose to be an electrician or if you decide to open a landscaping company?
Opportunity costs also impact your personal happiness. Ask anyone who’s ever been divorced what their life would be if they didn’t get married, or were married to someone else? Or, what if you decided to pass on buying your dream house because the timing wasn’t right, and learned it increased significantly in value two years later?
In money and finance, opportunity cost can have a major impact on your life path. Not saving for retirement until age 35 instead of starting at age 25 could mean hundreds of thousands of dollars less when you finally call it a career (which is a substantial opportunity cost). Or, passing on an Amazon.com-like stock in favor of a stock that never takes off could also alter your financial path in life, and thus also represents an opportunity cost.
Another way to consider opportunity costs is to consider how history would have changed if John Lennon and Paul McCartney decided not to start a rock and roll band, or if William Gates decided to go work for IBM instead of starting his own software company.
Certainly, both music and business would have changed dramatically if those scenarios had come to pass.
How to Calculate Opportunity Cost
While there is no hard and fast mathematical formula for figuring out opportunity costs, that doesn’t mean you can’t weigh considerations that could sway cost decisions in one direction or another.
In general, the formula for figuring out your opportunity costs is as follows:
Opportunity cost = What you are sacrificing / what you are gaining
Let’s take a closer look at that equation:
By and large, opportunity costs are all about options – and weighing those options before choosing one alternative or another. The goal here is making a decision that leads to value, i.e., what am I getting out of sacrificing one outcome, be it financial or lifestyle-oriented, and what am I gaining out of making an opportunity cost decision?
In that equation, the formula for figuring out opportunity costs gain clarity. Essentially, opportunity costs are what’s left over after measuring what business, financial or lifestyle outcomes you gain against any sacrifices you’re making. Basically, you’re evaluating the “value” ratio between two or more options to accurately gauge opportunity costs.
Think of opportunity cost calculations in these real-life terms.
Imagine if you’re considering a career move, from a public relations staffer to a public relations freelance specialist. While salary isn’t the only factor in that decision (being your own boss, less need to commute to work, and having the chance to work for multiple clients, are also big factors), money is a big driver of opportunity-cost decisions.
As a corporate, full-time public relations staffer with 10 years of experience in the field, you were making what amounts to $35 per hour. As a newly minted freelance P.R. specialist, your income will likely be lower as you start out – let’s say $17.50 per hour.
At first glance, it appears you’re taking a big pay cut – and you are. $17.50 is, after all, half your hourly income as a corporate employee. But opportunity cost isn’t so easily measured that way. The correct formula is to factor in sacrifice versus gain. In this instance, you’re giving up $2 as a public relations freelancer for every $1 you’re earning as a public relations freelancer in opportunity costs, right out of the gate.
Yet the chances are good that you’ll grow your business. That’s because you’re a smart, motivated and experienced P.R. professional who may well earn $70 per-hour running your own business within a year or two. In other words, the gain is worth the sacrifice.
And that’s an opportunity cost consideration you need to make.
Three Key Factors of Opportunity Cost
Ultimately, any worthwhile formula for measuring opportunity costs weighs on three key factors: money, time and effort, otherwise known as “sweat equity.”
With financial considerations to weigh, the key question to ask before making an opportunity cost decision is what else would you do with the money you’re about to spend on a single decision? The landscaper who chooses to spend $3,000 on mowers will have the mowers, but will never get that specific $3,000 back. That $3,000 that could have been spent on part-time help during the busy season, or on a new and improved website, is the opportunity cost of choosing to buy the lawn mowers.
Never forget that time is a commodity, too, just like ball bearings and Barbie dolls. In the opportunity cost realm, time can be even more priceless than cash. Consequently, when making any big lifestyle decision, always factor in the time needed (or saved) by choosing a specific opportunity.
3. Effort/Sweat equity
If you choose to start your own business instead of climbing the corporate ladder, for example, factoring in the extra effort needed to make a start-up business work should be a priority. That extra effort, which could lead to a successful start-up company, could constitute an opportunity cost that is missed if you decide to stay on the corporate track.
Terms Related to Opportunity Cost That You Need to Know
Opportunity costs are rarely cut and dried, and impacts that are both positive and negative come into play. Consider these key factors:
The law of increased opportunity cost
When considering opportunity costs, it’s tempting to think like an accountant and weigh the cash you’re spending (the sacrifice) against the cash you might be getting (the gain.)
But there are ancillary factors to consider, too. Take the law of increased opportunity cost, which can take place even if you don’t spend a single dollar. Think of a coffee shop owner who takes a staffer off the register and asks him to work stock shelves, and away from customers. That could impact short-term sales, as the worker isn’t directly waiting on customers and pouring coffee. But if the inventory isn’t stocked, the business suffers, too, as customers have fewer options. If you send more workers away from the register to stock shelves, however, the front of the store counter-help thins out, and you’ll likely lose more customers and more sales. That simple decision to send a coffee shop staffer away from the register is a good example of the law of increasing opportunity cost.
In terms of opportunity costs, comparative advantage means a company or an economy is producing more goods or services at a leaner opportunity cost than competitors. An example of comparative advantage lowering your opportunity cost could include outsourcing part of your production to a country that provides better economic value for that service.
By definition, sunk costs are costs that were incurred in the past, and are unable to be recovered. In real-world terms, buying an expensive watch that you lose at the beach is a sunk cost. A sunk cost is not always a bad thing for a business, and is sometimes simply inevitable; for example, replacing machinery in a factory means trying to scrap the old machinery. Anything that can’t be scrapped is a sunk cost. Relative to opportunity costs, sunk costs shouldn’t factor into ongoing opportunity cost decisions, as they cannot be adjusted or changed.
Trade-offs are the trigger for opportunity cost decisions. For example, if you have $100 and you have to decide whether to buy a new winter coat or take your SUV in for an inspection and oil change, choosing one over the other leads to a trade-off, as you can’t have both. If you choose the coat, the trade-off is that you can’t get your vehicle in for servicing, which is your potential opportunity cost.
Cite This Source
In practice, economists tend not to talk about early birds and greener grasses. They’ve developed their own more technical vocabulary to describe the world of scarcity and choice.
For example, when we sacrifice one thing to obtain another, that’s called a trade-off. Only have enough cash to buy a bike or a snowboard, but not both? That’s a trade-off. Trying to decide whether to take the Fourth of July off to spend with your family, or to go to work and make extra overtime? That’s a trade-off.
Trade-offs create opportunity costs, one of the most important concepts in economics. Whenever you make a trade-off, the thing that you do not choose is your opportunity cost. To butcher the poet Robert Frost, opportunity cost is the path not taken (and that makes all the difference). You bought that bike? Then the snowboard was your opportunity cost. Decided to work on the Fourth of July? Your opportunity cost was a relaxing day hanging out with the fam at the BBQ.
Everything has opportunity costs. If you just bought something, you could have always chosen to buy something else instead. If you just chose to spend your time in a particular way, you could have always done something else. “Something else” is your opportunity cost.
Why It Matters Today
Sometimes opportunity costs can vastly exceed the sticker price of an item. Imagine you scored a ticket to the Super Bowl. You paid $200 for your ticket, a stretch for your budget but worth it for a once-in-a-lifetime opportunity. You sit down in your seat next to some schmuck who admits he paid $5000 to a scalper for his ticket. Five grand! That’s madness.
But hold on. Your ticket just cost you five grand, too, even though only $200 in cash ever left your wallet. How’s that work? Well, if the schmuck next to you was willing to buy a seat for $5000, then you could have sold yours at that price, too. The opportunity cost of you using your ticket is the five grand you didn’t make by scalping it.
Hope it was a good game!
Sometimes, a Song Says it Better: Should I Stay or Should I Go, by The Clash
This is classic opportunity cost (trade-off) analysis – should I do something or not?
Should Opportunity Cost be Considered in Travel Hacking – The Four Great Debates, Part 1
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Should Opportunity Cost be Considered in Travel Hacking
I am sure everyone has heard the saying, don’t talk religion or politics at a party. There are four items that are the travel hacking community’s version of that saying. I wanted to take some time to explore these topics and give my thoughts on them. I am hoping to have a civil (key word there) discussion on it in the comments section. Everyone has their own take on these topics and I would love to hear all sides!
When Shawn interviewed me for this job he asked what I could bring to the blog that it doesn’t already have. And I replied that I think I have a different take on most things when compared to the norm. Sometimes I like to play the devils advocate just for the fun of it. Fair warning, I go against the grain on most of these hot topic issues. I believe open discussion on topics makes life interesting. Open discussion also pushes people to try different approaches and to consider different ways of thinking.
This will be broken into a four part series. I will discuss one of the four topics each Saturday for the next four weeks. This will give us ample time to debate and discuss each topic.
The Four Topics
The four hot button topics that we will be discussing over the next month are:
I will link back to the previous posts in the series as we move along. This weeks discussion will center around opportunity cost.
Opportunity Cost Defined
I think opportunity cost is the most discussed of the four topics so it is probably a good place to start. Many travel hackers believe that you need to account for opportunity cost when computing the”true” cost of a trip.
What is the definition of opportunity cost? According to Investopedia the definition is:
“Opportunity cost refers to a benefit that a person could have received, but gave up, to take another course of action. Stated differently, an opportunity cost represents an alternative given up when a decision is made. This cost is, therefore, most relevant for two mutually exclusive events.”
They break it down even further on their website. The calculation for opportunity cost is:
“Opportunity Cost = Return of Most Lucrative Option – Return of Chosen Option”
Pro Opportunity Cost Debate
The most used comparison when calculating opportunity cost, in our hobby, is a standard 2% cash back card. The thinking is that if you put that $3,000 in minimum spend on a 2% cash back card you could have $60 in cash. The claim is that when you are earning a sign up bonus worth $7-800 it is essentially costing you the $60 you forgo by not using the 2% cash back card.
The other time opportunity cost comes up is on the redemption side. Let’s say you earn 50,000 Ultimate Rewards points from racking up 5x spend with your Ink Plus or Ink Cash card. After earning these points you decide you want to stay at a Hyatt that costs 25,000 points per night for a weekend getaway. The argument is that the room is not free since you could get cash for those UR points at one cent a piece. So the room really cost you $250 since that is the cash value you gave up to use the points.
My Take On Opportunity Cost
For the most part, I do not agree with this line of thinking. Mainly because in travel hacking you are almost always taking the most lucrative option available to you.
Opportunity cost is a tool used to make decisions not a true cost calculation. You will not find opportunity cost displayed on any fortune 500 company’s balance sheet or income statement. They use it every day to ensure they are making good, informed decisions. It does not affect their bottom line. If it doesn’t affect their bottom line then it doesn’t affect ours. It is a theoretical cost. Not to mention that this calculation does not take into account that you are still earning points, most worth around 2% or more with bonus categories etc., for the regular spend on top of the sign up bonus.
Where this argument holds more water for me is when you are talking about using points that have a cash value like Ultimate Rewards points. Since they are all worth 1 cent a piece if cashed out there is guaranteed value there. If you transfer 5,000 points to Hyatt for a free night at a Hyatt Place did that really cost you $50 since you could have cashed those points out? This is a more valid argument in my opinion and I struggle more with this side of the argument.
What I would say in opposition of that argument is you are getting more value by transferring them so you are using the more lucrative option. And the points were always intended for travel so that should be taken into account. I also believe that if they didn’t cost you anything to acquire them (no increased spending fees etc.) then there was no cost to you. If you did not have to take any money out of your budget to accrue the points then should opportunity cost be factored in? Or, should we only look at true cost and if there was any expense to acquire the points?
Is opportunity cost a true calculation of cost or just a guideline that is used to ensure you are making the best decision? I tend to go with the latter.
This is a truly interesting debate in which I think both sides have valid arguments. I tend to look at it from a more business like approach of balance sheets and bottom lines. I think opportunity cost is more of a philosophical approach. This is assuming that no cost was incurred acquiring the points.
I look at opportunity cost as a tool you use to make an informed decision. If you were to redeem those UR points at .8 cents a piece for a hotel stay then looking at the opportunity cost would show you that it was a bad decision. It would be better to cash out the UR points at 1 cent a piece. You could then use that cash to pay for the room and come out ahead, making it the most lucrative option.
I know this thinking goes against the norm but I would love to hear your take on it. Please try to stay civil in the comments. Remember that this is a discussion of opinions there are no 100% right answers.
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[…] 10. The first article in The Great Debate series…is opportunity cost real? […]
[…] part series that discusses four of the most hotly debated topics in the travel hacking community. I discussed opportunity cost last week. This week I would like to discuss if award travel is really […]
I am surprised no one has mentioned the opportunity cost of labor. That is the concept we studied in Economics and has been frequently questioned on miles & point blogs like this one.
Take, for example, a reselling deal that may earn points and cash. The blogger spells out the deal/scheme and invariably gets asked at what rate their labor is valued. Many folks won’t spend time or effort without a minimum payout. The blogger typically can relate a figure such as $100 an hour, though very few people in this World get that kind of pay for their spare time!
Each of us taking the time to read and/or respond today is experiencing an opportunity cost.
Good point Dave. I always look at time valuations as a slippery slope. If you are trading tv time for time spent gaining knowledge or something along those lines then it is a good trade off imo. But everyone has their own calculations that they need to make when it comes to time. I didn’t include it because I think it would be need to be looked at on a case by case basis. There are a lot of varying factors that go into that equation.
Thanks for the great comment!
Points have no value the experience has value. The only opportunity cost is the opportunity to have the experience or not. Do I want to spend the points or the money on that specific experience? That is the question that matters to me. The currency I use for that experience is not important to me. The energy spent on figuring out all these extraneous items to the experience is just noise in my book and I have no energy for them. They add no value to me to figure out if that is the travel experience that is right for me. If getting a steak at Applebees is right for you great if getting a steak at Flemmings is more your style enjoy it. There is a difference on so many levels even if people want to just compare the cost.
Points make a ton of experiences I wouldn’t be able to do otherwise possible – which is a pretty cool thing. I agree with your sentiments and will touch on it in the 4th article in the series.
Wow, this article and comments were fun to read, and Jay’s comment got me thinking about the value of fun itself. I totally agree that calculating the opportunity cost of every transaction and redemption is only worth it for those of us who enjoy that part of the game. The calculations and obsessive attention to detail satisfy my inner Sheldon Cooper. For people who don’t get their jollies by creating unnecessary math problems, I always recommend keeping it simple: earn three big bonuses per year and never accept less than 1.25 cents per point on a redemption. Following those two rules will get most people a huge percentage of available rewards with a tiny fraction of the thought.
For those of us who prefer redeeming for first and business class seats we would never pay cash for, I’ve started to realize there’s an opportunity cost to that as well. Specifically, if I’ll never settle for less than 2 cents/point, it means a lot of times I’m going to pay cash for flights I could have had for free, even while I’m sitting on a mountain of over 1.6 million points and miles. If I can’t spend them as quickly as I can earn them, I’m starting to feel like a sucker for never letting myself save $325 by redeeming 25,000 miles. I wonder if anyone else has thoughts on the opportunity cost of always refusing to accept a mediocre redemption.
That will come up in the 4th article in the series…stay tuned Kevin :).
Thanks for stopping by and commenting!
As Mark stated he hoped this would be an open sensible discussion as we all have our own points of view. So far the article and reader comments have been excellent and provide lots of “food for thought”.
I honestly had not really thought about “opportunity cost” before for my redemption’s but I’ve always looked at the value I’m getting for the points when making a decision as to whether to use points or pay cash and earn additional points. In my view the points I earn from actual travel/spend and signup bonus is free money but again that’s my POV.
I travel on business several times a year and that gives me the opportunity to earn in my primary programs Delta and Hilton. I have even used my Delta points in the past to pay for an upgrade to First on some of my domestic trips as I’m interested in my personal comfort.
Recently my wife and I took at long weekend trip and I used some points and some cash. First of all my Delta Reserve card gives me an annual companion pass which allows booking in First so I paid for my ticket and earned miles and MQM (to help reach Platinum again) and look at that as a huge offset to the annual $450 fee for the card. I used Hilton points to book a great property and then opted for the upgrades they offered at reduced rates. So I earned several bonus points for the cash spend but also used some of my Hilton points at around a 0.5 cent rate.
We have an upcoming trip for Thanksgiving and again I’ve used some dollars and some points. The decision was made based on redemption rate and whether the point earn is worth the cash. I have some hotels I’m paying cash for since the rate was so low vs. the points and another where I’ve booked a nice suite using points where the redemption rate is only 0.4cents but we get a great room for no cash outlay. We chose to pay cash for our flights since booking well in advance the rates were so low and we paid for premium seats in economy (short flights 3 hr).
For me the points/miles allow us to redeem for some great personal travel and usually to fly First class or Premium economy and stay in upscale properties.
Keep up the thoughtful comments as it always help all of us to learn about other options.
Michael I couldn’t agree more – the comments have been amazing. I couldn’t have dreamed it up any better. Thanks for reading and I hope to see you next weekend for the next article in the series!
Interesting debate and I look forward to the rest of the series. I also have used miles/points to enhance trips, but sometimes I take a slightly different tact with my miles and points. For example I wanted to meet my sister and niece at the end of her school trip in Dublin and go to Great Britain (and pay for it) for 5 days with them as a graduation gift for the niece. All the hotels and my flights and their flights home were on miles and points and taxes were paid with my Arrival. The trip had to be at a specific time and the place was my niece’s dream trip. I really did not look at the value of those miles and points. I looked at what I had that could get me a room for three for five nights and the flights I needed. I also flew business to meet them but that was a splurge for me. Sometimes travel does not happen at all without miles and points and if you want to go on the trip value is not your most important issue. The trip this summer would not have happened if I had had to pay with cash. Miles and points made it happen and seeing my niece enjoy her dream trip was worth every miles and point spent. Thinking about New Zealand for her graduation from college present in 4 years.
Sounds like a great trip. Using miles and points to bring family together is the best use out there in my opinion!
Thanks for the comment L
Thanks for the topic, Mark, and thank you to all the other readers for your comments. I’m brand new to the points/miles world (still in the collection phase), and I greatly appreciate the various perspectives everyone brings to the table with regards to collection/redemption. I’m definitely taking it all in, and plan to apply it all to get the best value for my points/miles in the future (whatever the definition of “value” happens to be at that time…) I look forward to the rest of the series!
Thanks for reading Matt – I hope you enjoy the rest of the series.
It’s a bit difficult here to understand exactly what point you’re making: that there aren’t opportunity costs, or that they are overstated by some people. I frame the debate a bit differently:
When we talk about the value we receive from travel rewards, we should talk about net, not gross value. Net being that which we receive above our opportunity cost.
For example, if we spend $10K on a CFU, transfer to Hyatt, and redeem for a 15K free night with a cash cost of $300, our net value above putting the same spend on a 2% CB card is $100. We could have earned $200 in cash instead. It’s not accurate to exclude opportunity costs when valuing our points.
However, I am sympathetic to the argument that opportunity costs can be overstated. For people who are earning points simply through churning sign-up bonuses and maximizing regular spend, opportunity costs are very minimal.
But for those of us doing several $100K+ of MS per month, there are cutoff points at which using a simple 2% CB as a benchmark is not appropriate. Most of the 2% cards are issued by banks that are not very MS friendly (Citi, Elan (Fidelity), Barclays (if you include Arrival+ even though it’s not really cash etc.). At some point, accounts will be shut down, and the next best alternative results in a lower opportunity cost.
I am kind of torn on the topic so that is probably why it comes out a little unclear. I guess I would summarize it as this:
Opportunity cost should be used as a decision making tool but it should not be added into to your calculations for the cost of the trip. The only thing that should be included when calculating the cost of the trip from redemptions is the cost you had to accrue the points. Whether that be the annual fee or fees from gift cards etc. I don’t think opportunity cost should be included in that calculation. Does that make more sense?
Thanks for the comment!
My only reason to collect points is to enhance my travel experience. There is no way I would pay the cash required to fly first or biz class, and/or stay in upgraded rooms. Therefore, if I calculated the opportunity cost, or took cash instead, I would not derive the same pleasurable experience.
100% with you, John!
I also agree 100% with John. I am only in this hobby to enhance my travel pleasure.
I will not waste my time on minute calculations on the opportunity cost of using points. I will make vastly more money making calculations on my stock portfolio than on my points and miles.
Spending time on calculating the opportunity cost of using points is a waste of money, unless the person doing it is just doing it purely for the fun of it or if they don’t have opportunities to use their time more productively.
Thanks for the comments John, Pam, and Jay
Opportunity cost for me is what room/flight upgrade would I be missing out on by accepting a certain redemption? If I spend, for example, 95,000 Hilton Honors points on a Standard Room award at the Waldorf-Astoria, could I have instead parlayed those points into a much more valuable Signature Suite by taking advantage of a promo and/or cobbling those points with a promo/ upgrade/free night package?
In other words, I am most concerned with the overall value I am receiving from my redemption rather than its singular dollar cost, though the final result would also typically be considered a “deal” by its very nature. I evaluate the cost but mostly if the redemption serves my wants/needs. I recently earned a suite at the Dolce Silverado Resort by mattress running 2 stays at a $35/nt Super 8 in BFE. I spent $80 ttl at a flea bag property for the opportunity at a $400, 700 sq ft self-standing lovely cottage in wine country. I am personally not very interested in this example with the very little money a cash back card would award me – I iam mstead seeking a better room and experience.
Good point – thanks Pam!
It absolutely is reported on a company’s income statement. Cash back is considered a reduction in cost. So if a company charges $1,000 for widgets on a credit card and receives 2% cash back, the expense is $980, thereby reducing expenses. If the company decided to forgo the 2% cash back, expenses are increased. The income statement doesn’t have a line item that says “opportunity cost” because its already baked in.
I would disagree with you here some. I don’t think taking the 2% in credit to reduce your cost is opportunity cost. Let’s say the company could have gotten 5x UR at Staples for that purchase instead of using the 2% card. The opportunity cost would be 3% that they missed out on….that is not found in your calculation.
Also the company would be better off using the Ink earning the points and then transferring them to Southwest etc. to book a flight for a sales pitch or a convention etc. That would save them 7.5% on their Staples purchase because they are offsetting their costs on the flight. Where would they put in the calculation for opportunity cost on their income statement? It would just be considered a savings of 7.5% since it didn’t actually cost them anything to accrue the points. And they would have taken the most lucrative option anyways.
TAKING the 2% cash back would not be opportunity cost. Losing them would be. The opportunity cost shows itself as the difference in expense. In your scenario above, I believe accounting-wise, you would not book the 7.5% as an offset to the Staples purchase. I believe the UR points would be booked as an asset when earned. When the flight was booked, the asset would get depleted (or reduced). I’m not saying its a bad trade – I would definitely give up 2% for the 5x, but you still have to account for the fact that you’re not getting 2%. On the flip side, if you chose to use a 2% cash back card vs earning the 5x UR points, the opportunity cost would show up as a reduction of assets (UR points). Its been a LONG time since I’ve done accounting, so I’m guessing at how a company would book the UR points. Would be interesting to hear from an accountant. Interesting topic!
Opportunity cost is not income that you receive or expense that you spend. It is the benefit you COULD have received by taking an alternative action. so it is unrecorded.
If you have been receiving 2% cash back and then decide to go another route, you will see that loss of 2% as a reduction of savings (or increase in expenses). In that scenario, it is recorded.
The costs on an accountant’s balance sheet are explicit costs. Explicit costs require a money payment. Accounting profit is therefore Total Revenue – Explicit Cost.
Economic profit, however, is Total Revenue – Opportunity Cost (includes explicit costs paid and implicit costs not actually paid). They will therefore usually be lower than accounting profits because they include implicit costs not found in accounting profit.
Opportunity cost is one of the most important ideas in economics, but not accounting! It helps with management decision making but is not otherwise reflected on/considered in the company’s financials.
I agree that when looking at some opportunity costs, there is no explicit cost. However, in the scenario regarding the 2%, there IS an explicit cost. You either see a reduction of expense (because you deduct 2% from your total expense when charging on a 2% cb card), or not. Since expenses are reported on an income statement (not balance sheet), your opportunity cost is baked into your expense line. My point is that some opportunity costs are reflected in reporting, even though it may not be obvious.
Does this matter? Only if the basis on our discussion is that one shouldn’t “count” opportunity costs since corporations don’t. I believe that to be false. Since I’m not a corporation, I don’t really care. If I choose to get 5x UR points vs 2% cash back when purchasing product at Staples, I absolutely must account for the loss of 2%. I find the opportunity cost to be fairly insignificant in this case, but I think one must account for it.
Again, opportunity costs INCLUDE explicit costs!
This all is only important if you want to know your true accounting cost & not the woulda/shoulda/coulda element.
Also JP, expenses reduce profits – when an expense is tecorded, the equity section of the balance sheet always declines by the same amount as the expense.
Opportunity cost also does not necessarily involve money (as it alternatively would with accounting if it WAS included). It can also refer to alternative uses of time.
Opportunity cost therefore doesn’t even always work! It can be too difficult to make a quantitative comparison of two alternatives. It works best when there is a common unit of measure, such as money spent or time used. More time, for example, could be spent on a mileage run than buying miles at a discount even though the financial effect of owning X miles at the end of both efforts is the same.
Thanks for the comments Pam and JP – great discussion!
I’m also a contrarian, and I believe you underestimate how expensive opportunity cost can be. Define it as what remains after you subtract the value of all the options you did not take from the value of the option you did take, and the opportunity cost of Hitler’s decision to invade the Soviet Union in 1941 was losing World War II. Of course, it didn’t look that way at the time. The conundrum of opportunity cost is that it nearly never is as clear in foresight as it is in hindsight, and that’s mainly because we never have perfect information. To draw an analogy specifically to this game we play, how many people do you suppose lost out on the 100K CSR because what turned out to be 5/24 was a credit card that gave them 20% off on a nice department store Christmas sweater nine months before CSR was introduced? In short, opportunity cost exists, and since we can almost never judge it accurately when a decision is made, we have use our best judgement and learn to live with the results. I mean, you did get 20% off on a nice sweater, right?
Great points Mike – dropping some knowledge on the group. I wish I knew 5/24 was coming down the pipelin so I could have snagged some more Chase sign ups instead of some other junk for sure haha.
Thanks for the comment!!
using chase UR to convert to Hyatt for a night in Park Hyatt tokyo vs a capsule hotel for 25 USD. i sleep well in both, and i probably like the accompany in a capsule hotel. but people obtain the price of chase points via the cash cost of Park Hyatt tokyo/points per night to obtain the cost.
Personal choices definitely play a part in these decisions and that is why nothing is one size fits all in this game.
Thanks for the comment Alan.
I generally look at how much a booking will cost me vs. what I would buy if I didn’t have points. This leads me to almost always trying to get a cash value out of points rather than redeeming them. I am vehemently opposed to valuations which justify flying first class vs. the coach class I would ordinarily purchase. I find with this perspective that the 3-7 cents per point valuations are almost always exaggerated. Example one of the best redemptions using Hyatt points is a category 1 Hyatt place hotel. I recently booked a hyatt place with a Hyatt.com advertised rate of $153…. seems like > 3 cents per point and a no brainer reservation. But I could book a Choice hotel on a travel site for $62 a night with cash. The Choice hotel is comparably clean and gives a comparable free breakfast. A bit less prestige perhaps, but in general pretty equivalent. Moreover, I found that the Hyatt room with taxes included could be booked for $115 nightly rate through almost any travel portal (advertised as low as $95 per night without taxes). I looked at booking the Hotel through the UR portal and found that a competitive rate was not available for either hotel even with the 50% bonus. I didn’t have any Chase points so I gave up there. Hyatt points won out, but just barely. I’d rather have 1.5 cents per UR than any of these options. Fact is, almost no one will pay 1.5 cents per UR. If I’m wrong I’d love to get some offers.
Good points Nateo! You always come at it with a unique approach and I appreciate that.
Thanks for commenting.
I disagree with your take on Fortune 500 conpanies not reporting opportunity cost. It is captured in the ROI – return on investment. A company should return at an acceptable rate on any investment they make. It accounts for what they could have earned using their cash somewhere else, like bank interest or bonds. You should always think about opportunity cost.
Great thought starting article!
I think of ROI as a separate calculation (vs opportunity cost) to make sure you will recoup your investment in an acceptable time frame. Each industry will have a different definition on that. My previous industry 40 weeks was an acceptable time frame.
I agree you should always consider Op Cost when making a decision but I am not sure it should be used as a true cost calculation in this hobby. That is my take at least.
Thanks for reading and thanks for commenting!
I ignore most opportunity cost just because that’s not why I get into points and miles. If I wasn’t going after travel redemptions, I wouldn’t sign up for cards or increase my credit card spend through MS or reselling gift cards. It wouldn’t be fun or worth my time if I was going for cash, so I never would realize the 2% cash back as another alternative. When replacing every day spend, I could see the argument with opportunity cost but it’s a small portion of my credit card spending and negligible to me
Kind of the same boat as me Robert….thanks for the comment!
I don’t think using $.01 per point is fair. Most people with UR will have the Sapphire or Reserve and will be able to get $.0125 or $.015 through the travel portal. But even that’s low-balling. You said it yourself “a sign up bonus worth $7-800”. How do we arrive at that valuation? We multiply the number of points by their subjective value. For UR, that might be $.018, which is the value you might be able to reasonably average with redemptions. So your 25,000 point room is now $450. That’s how I calculate my opportunity costs.
Unfortunately as of late, the more difficult it gets to get that 1.8 cents worth of value (lack of saver awards for the desired travel period), the lower the value of UR and the more enticing to save the cash. It’s a balancing act in the end, not an equation.
Also at play is how easy it is to replace those points and your current balance of them.
Good points Marvin. I agree with the fact that it is a balancing act in the end. And how easy it is to earn the points plays into it for sure. UR’s became a lot harder to rack up with the loss of PPDG and Cardcash at 5x.
Thanks for contributing!!
Excellent article. I have been so happy you joined the blog crew. Thanks.
Thanks John – I’ll keep writing if you keep reading
There is another kind of “opportunity cost” to consider: When you use points or miles, you are often foregoing the opportunity to accrue more points or miles by paying the fare with your credit card. I usually factor this into my decision-making.
That is a good point Tom – I always consider that when the redemption is close to cash.
Thanks for participating!
Exactly. In my playbook there is a time to pay cash…for example, Mark & I both like to go to New Orleans. If I see a flight for $300 (since EWR is one of my hubs, it is on UA), I check the point redemption. If it is the standard 25K RT, using my own formula, I will get a $.012 point redemption. Bleahhhhhhh….that is not a good redemption. So maybe I will cash in my $250 flight credit from my Prestige card, leaving me with a $50 payment to make and some extra points. Since UA has devalued redemptions, I know that I will probably never use points for that flight. Other people think differently, one discussion I had with someone was based on their theory that “points are free, use them for everything, regardless of the redemption”. Good for them, not for me.
If I didn’t have a travel credit I would probably use Thank You points at 1.25 cents through their portal to book the flight
But I don’t place much value in TY points.
Mark, I respect your thinking but your reference to how companies don’t report or think about their opportunity cost is absolutely false. Anyone with basic business or finance education will tell you that opportunity costs are business leaders think all the time. Give you on simple example, if company’s cost of capital is 12%, it will not invest in any project that has 8% return…because their investors opportunity cost is 12%. Anyway, you get the idea.
I never said they didn’t think about it. I actually said they use it every day. But I said they use it to make informed decisions not as a cost measure. It is a tool not a true cost calculation. Thanks for commenting!
I take a simplistic approach to this. 1) Points are not free, you have to spend money to get them, and invest time into the game. Time is money. Banks pay for points they hold for you. They cost money.
2) In the decision process of evaluating an award cost, using the assumption that points start off at $.01 in value, I simply divide the cost of the award by the number of points needed. If the remaining number is less than $.03, I think hard about the award. If it is over $.03, I am happy. If the number is $.05 or more, I am very, very happy.
Sounds like a good/simple way to look at it. Everyone needs to find what works for them. This is definitely not a one size fits all type of game.
Thanks, as always, for reading and commenting Chris!
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