Eddie’s new day is Wednesday. (Checks calendar) Hey wait. That’s today. Here he is.
Let me pose a fictitious story to you to illustrate a very important point.
Jane works at a local grocery store as a produce manager. She excels at her job because she is knowledgeable, driven, and charismatic. On the last day of 2011, she sat down with Bob, her accountant, to discuss her finances. Bob informed her that she made $80 000 over the year. Jane was happy and they both said goodbye.
On January 1st, 2012, Jane leaves her job at the grocery store to open her own produce store. She worked hard to build a customer base and has managed to stay afloat. At the end of 2012, she sits down with Bob again. He informs her that her profit from her store was $60 000. Bob and Jane say goodbye.
Jane then speaks wither friend John, who is an economist at a financial services firm. She explains her situation and that she pulled in less money than last year working at the supermarket. Although she made less money, she said that Bob calculated her profit to be $60 000. John said the profit of her self-employment was -$20 000.
Who was right?
Both were right. Bob gave her the figure of her accounting profit. At her store, Jane’s revenues less expenses was $60 000. John, taking opportunity cost into account, calculated the negative figure. The reason why it was negative is because the opportunity cost of Jane opening her store was her salary at the supermarket was $80 000. To obtain economic profit, opportunity cost must be subtracted from her revenues. Jane essentially took a $20 000 pay cut to open her own store. Bob was right because he gave her the figure of accounting profit whereas John gave her economic profit.
Both are useful. Bob’s figure conveys the fact that her enterprise has a positive income and cash flow, which is important in Jane’s decision making processes. If her accounting profit was negative, she would likely be in serious trouble. If she can live off of $60 000, then she is doing relatively well. John’s figure is important to her decision making processes as well. Economic profit serves as an effective contrast between two options: keep her store or go back to the supermarket. Is her independence and the expectation of future profits worth the $20 000 she gave up? She must decide.
Why this is important is because we should take opportunity cost in making decisions regarding our time and money. What is the opportunity cost of sleeping in until 2 pm on weekends and doing nothing productive? It could be the higher salary you could attain if you took some continuing education courses. What is the opportunity cost of not getting your oil changed regularly? The cost associated with a hefty repair bill due to poor maintenance. What is the opportunity cost of driving across town to get $5 off an item you can purchase at a store close to home? The tank of gas you burned to drive across town and the time you invested to do it. You get the idea.
I keep harping on opportunity costs because recognizing them is critical in ensuring you are at your most productive and spending time on high value projects. If financial freedom or independence is important to you, which I assume it is based on your readership of this blog, then you probably require much more money than what you have now. To achieve the wealth you desire, you need to scale your thoughts and subsequent actions to match the enormity of your endeavor. To this end, I have the following observations, expressed in do and do not form:
DO thoroughly understand the concept of opportunity cost, and how it relates to accounting and economic profit.
DO reflect on the implications of opportunity cost on your current allocation of time and money.
DO NOT think that clipping coupons and combing flyers will make you wealthy; it will never. I will jump off a tall bridge the day I read Fortune 500 and read about a billionaire who made their fortune by clipping coupons and putting their money into a Tangerine Savings Account at 2 point something percent.
DO focus on the revenue aspect of your income statement and focus less on cutting expenses.
DO NOT get a menial part-time job to cover expenses unless you are teetering on bankruptcy.
DO invest strategically, particularly in assets that are difficult to quantify the payoff, such as education and skills upgrades.
DO read biographies of highly successful people, rather than the tales of “successful” PF bloggers. (PS This also includes my lifeless blog, as I am discovering that the opportunity cost of writing for it may be too high).
If you want to get yourself into the right mindset, ask yourself what you would do if you wanted to retire in 5 years rather than 20 or 25 years. Treat the 5 year stipulation as fixed or unalterable and research options that will put you into that ballpark. I like the franchise and real estate route and leveraging a corporate structure, but that is for another day.