If you took finance or accounting in school, you would have known the concept of alternative cost, also known and used interchangeably as opportunity cost. And no, you don’t have to be a financial expert to understand and use this concept. Let me start with several examples

Let’s say, you are working right now, with a salary of $30,000 a year. Not so happy with the current job, you decide to take 2-year college program that costs about $40,000, but will increase your annual salary to $50,000 once graduated. Now, most people only think of the cost of going to college, the $40,000, without thinking that you will lose 2 years of income from your job: $60,000. This 2-year income of $60,000 is your alternative cost for going back to school full time.

Here’s another example. You don’t want to spend $20 for the pizzas, so you decide to cook this evening. Again, most people only think of the $20 you will save in this case. But there’s always the alternative cost. Beside your time and labor to do the cooking, you will still have to shop for groceries, add more cost to electricity or gas bill. Suppose we can calculate that the groceries would cost about $10, energy would be $1, your time would be $5, then the alternative cost in this case is about $16.

OK, so why would you care about alternative costs? Well, because that’s what cost you! When you make a decision that involves your finance, you’ll always have to consider the alternative cost to come up with the best choice. For the pizza example, cooking would save you $4, so should I cook or get take-out? While the final decision will involve other factors such as whether you love cooking or get lazy, the financial factor you have is the $4 saving if you cook. Similarly, in the college example above, you have to add the alternative cost of $60,000 to the $40,000 program cost, to see whether the diploma makes any financial sense. While other factors may be more important in your decision to go back to school, financially you know that it will take you more than 5 years to get back your investment. Why did I stress the phrase more than 5 years? Because the alternative cost may extend further than just 2-year income. You would have to consider that when your future income increases, so do income tax brackets. Also, inflation plays a role as well. Every year the dollar (or any other currency, for that matter) will lose value. The same amount of money now won’t value the same later. If you don’t have the cash in advance, but take out student loans, the cost of borrowing will add to your alternative cost as well. For this example, also note that the $40,000 payment for college is after tax, meaning you would have to make a lot more than that to make up for it.

In summary, the concept of alternative cost is not only for financial experts, but widely applicable in everyone’s daily decisions. Whether you understand it or not, alternative cost always plays an important role in financial decisions.