Opportunity cost

9 Jul

Opportunity Cost

Posted at 13:51h

There are two ways to think about the price of anything. The first is the number of dollars it would cost to purchase that thing. The second is to think about what else we could spend our money on. This is called ‘opportunity cost’ and it is always worth remembering when you make a purchase.

We will start this blog with a question. When you spend money, how often do you ask yourself what you won’t be buying as a result of your spend? After all, you can only spend a dollar once. Whenever you buy something, that means there is something else that you cannot buy.

Financial advisers call this the ‘opportunity cost.’ Instead of expressing the price of something in simple dollar terms, the price can be expressed in terms of what else the same money could have been used to purchase. To give you an example: let’s say I only have $100 to spend. I can use that money to buy a microwave oven or a set of noise cancelling earphones. If I buy the oven, I cannot buy the earphones, and vice versa. The opportunity cost of buying the oven is missing out on the earphones. And the opportunity cost of buying the earphones is missing out on the oven.

We often forget about opportunity cost.

This is because it is perhaps relatively rare that we are faced with a choice between something like an oven and a set of headphones. Quite often, we aren’t aware of alternative things on which we could spend our money. As it happens, for most people there is almost always something else on which we could spend our money. Forgive us for sounding like financial advisers, but that something else is superannuation.

These days, most working Australians are able simply to deposit money into their superannuation account and claim a tax deduction for the deposit in their tax return. Most superannuation funds let people do that via Bpay, so that making a superannuation contribution is no more difficult than paying a bill.

One of the great features of deductible superannuation contributions is that, for anyone with a marginal tax rate above 15%, there is an immediate tax benefit. So, if I decide to buy neither the oven nor the headphones but instead put the $100 into my super fund, I get an immediate tax benefit equal to my tax rate times 100. If my marginal tax rate is 30%, I will immediately get a $30 tax benefit (to be enjoyed when I lodge my tax return). Of course, the $100 is taxed within my super fund, but only at 15%. So, I end up with $85 in superannuation and $30 in my pocket.

Looked at this way, we could argue that the actual cost of either the microwave or the headphones is actually $115.

What is the opportunity cost of those headphones

But that’s not where things end. Within my superannuation fund, that $85 will now be invested. Especially if I’m a long way away from retirement, that investment will compound within the superannuation fund. To give you an example, if I can achieve a 7% investment return within my super fund, my $85 will double every 10 years. After 10 years it will be worth $170. After 20 years will be worth $340, etc.

So the opportunity cost of money that I spend today can also be expressed in terms of reduced savings for my retirement.

The ability to put extra money into superannuation does depend on a couple of things. Firstly, taxable contributions within super are subject to a total limit of $25,000 per person per year. This includes things like superannuation guarantee contributions paid by our employer. So, if we have already put $25,000 into superannuation, there is no further tax deduction available. Secondly, making a taxable super contribution only makes sense if your marginal tax rate is above 15% so that the overall tax benefit is positive. Lastly, there are some loosely restrictive age requirements. Basically, any taxpayer under 65 can make a contribution. Between 65 and 74, the taxpayer needs also to satisfy a work test.

We admit that considering the effect of every purchase on our superannuation fund can take a lot of the fun out of spending! And we need to enjoy our money by buying things that are not absolutely necessary. But it is always worth remembering that a superannuation fund is often a great alternative to unnecessary spending and can even loom as the best place to simply save our money. This is especially the case the closer we get to retirement age (when we can take money out of the fund again).

If you’d like to know more about the simple process of putting more into super, talk to us today.


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