Before I started a career in buisness and marketing, I was about to become an economist. Supply, demand, efficiency, macro, micro-economics. These were interesting, but one of the most enduring concepts that says with me today, is that of Opportunity Cost – the cost of a forgone alternative.
When business cycles and markets moved slower, opportunity cost was less of a consideration. The loss materialised during a longer time period. Also, there were many other externatlities which muddied the waters and added complexity to the extent of the cost.
However, in modern, dynamic business environments, businesses can draw upon more data than ever to get a quicker realisation of the cost of a current course of action. In doing so, they can also, to an extent, calculate the cost of the forgone course of action.
A good example of this is when a brand will make a choice between one marketing agency over the other. If both agencies promise similar outcomes but the client experiences a poor experience with the one they chose, this can be a huge opportunity cost. The time, the expended resources, the lack of progression in their market, competitors gaining market share at their expense. A poor choice can cripple any business.
Another common example is when a brand will redesign their website or conduct a rebrand in the belief that this will be the antidote to their marketing troubles. However, often after this process has been completed, there is little to no effect on the bottom-line. It’s only after the fact that the team realises the extent to which large amoutns of time and money has been spent on something which has added negligible value to the business.
Opportunity cost is about choices and the cost associated with a poor choice. Make no mistake, opportunity cost if your largest business cost.
Business operations is a continual process where there are frequent moments characterised by compromises, trade-offs and judgement calls. If you’re a business ower with an ultimited daily task list, which tasks do you give attention and resources to first? Prioritization of tasks is a common way of limiting opportunity cost.
We’ve touched on a few situations already, but opportunity cost can be broadly arranged into five main categories:
A customer makes contact with you and requests a product that you might not provide. Unless you make money off a referral, you’ve lost profit from a sale, that’s the Product Opportunity Cost. Perhaps this happens very infrequently, so you offset the cost of the lost sale against the cost of managing and maintaining inventory. If enough people ask for the same product, you will quickly conclude that you need to be selling that product in order to not loose out on further future sales. This is an easy one – the decision whether to sell a particular product is usually quite simple.
This happens often in the services industry, when everyone wants to book at the same time – peak time but you can only fit so many in at that time. For physical products, perhaps you get a customer asking about a product that you sell but is out of stock. Unless you can convince them to buy something else or wait, you’ve got a high chance of losing the sale.
Inventory and capacity management are needed in this situation. Easier said then done, but you can use sophisticated forecasting or longitudinal data to predict demand for future time periods.
If you talk to an economist however, they will argue quite rightly that often it’s not just about a choice between A or B. Opportunity cost is typically non-linear and become higher at the margins.
We touched on this above, but most entrepreneurs and business owners are extremely conscious of their time and the associated costs. Even Warren Buffet admits that the only thing he can’t buy is more time. First you need to stop and consider the cost of your time. Should you delegate and train or do the task yourself. If you have a task that needs to be done, should you hire another employee to do it or invest in a system which automates that role instead.
Business owners need to have the analytical skills to understand what’s more valuable and important when it comes to their contribution to the business. Business development, relationship building, adding to or training the team, having a hand in large sales, scoping the next big strategic partnership…the list goes on.
Senior roles can have a time value between $150-$2000 per hour or more. Procrastination is a good example of time opportunity cost. Stress, anxiety and overworking can lead to unproductive behaviours to emerge such as analysis paralasis, lethargy, procrastination, demotivation, and poor decision making.
You decide to invest in one course of action with an expected rate of return. Say for example, this is a large TV advertising campaign because you’ve always wanted to have an advertisement on TV. You believe it will show to everyone else that you’ve ‘made it’ and you’ll be able to bask in that glory. However, if you’ve chosen that investment over other channels (against the advice of your strategist), in the hope of attracting customers and those new customers don’t materialize, you’ve experienced a direct financial opportunity cost.
Misinformation is a huge problem with decision making in a business setting. In fact it can be the most subtle and most expensive of all. This is when you don’t have the knowledge to even detect the presence of alternative courses of action. If you’re unaware of the alternative, you’re going to be unaware of the opportunity cost altogether. Opportunities are all around us but the thing that prevents us from taking them can be knowledge itself!
By investing in your own education and expanding your knowledge of a topic area, you are already reducing your opportunity cost. Business education and upskilling is so important for this reason.
One of the main benefits from contracting outside agencies, advisors, consultants and coaches is for this very reason. Sure, it takes quite a bit of time and money to increase your knowledge, bbut it infinitely beats the cost of ignorance.
The knowledge opportunity cost is a good example of a non-linear opportunity cost. In a big organisation where knowledge is held across the organisation by many people, there is a small cost to an absence of knowledge in an individual In a small organisation the chances are that only one person has the knowledge, potentially resulting in a big cost if that person is not available.
A business owner who works on his business understands the Opportunity Cost of his business not constantly improving and growing. A business owner needs to leverage him/herself to the point where most of his/her time is spent on the most valuable activities – working on improvement and growth.