Ever found yourself looking back with hindsight and wondering why you progressed with one opportunity instead of another? There is a good chance that at the time of making your decision, the Opportunity Cost of the seemingly less attractive opportunity was not fully assessed.
When we don’t fully know the value of what we’re giving up in order to progress a particular course of action, we can’t make a truly informed choice. Understanding the principles of Opportunity Cost is essential for making smart business decisions.
What is Opportunity Cost?
Opportunity Cost is a macroeconomic term that relates to scarcity of resources. Scarcity of resources – be that time or money – means that we have to make decisions about how we use what we have. Because we have to choose, we can only have the benefits of one option, and have to forego the benefits of the other. The benefits of the foregone option are the Opportunity Cost. Or as Bizfinance.com says:
“Opportunity cost is the cost of a foregone alternative. If you chose one alternative over another, then the cost of choosing that alternative is an opportunity cost. Opportunity cost is the benefits you lose by choosing one alternative over another one.”
Sushi or sandwich for lunch? Sushi. So, the sandwich becomes the Opportunity Cost.
Opportunity Cost in Business
We make plenty of choices in a business day that all have an associated Opportunity Cost. On a small scale, it might be how you choose to use the next two hours – to do a proposal for a client, or get the invoices out? One or the other. The benefits of getting the proposal to the client, or the benefits of getting the invoices out? Each time we weigh up the resources available and what to do with them, there is an Opportunity Cost of not pursuing one option.
Where the principle of Opportunity Cost is of greatest value for a business is in deciding which business opportunities to pursue. For these decisions, auto-pilot absolutely has to be switched-off. It is all too easy and common to unwittingly make decisions based on preconceptions. One option seems better from the outset, and this preconception then leads to an inaccurate assessment of the alternatives.
How to assess Opportunity Cost
When assessing Opportunity Cost, it’s important to keep these three things in mind: (1) to make an informed economic decision, the value of an opportunity needs to be assessed based on both the benefits and the costs associated; (2) broader benefits should be assessed as well as the monetary benefits; and (3) each option needs to be assessed based on the same criteria (i.e. don’t just assess the preferred option in isolation).
For example, a construction business has two opportunities on the table. Building Contract 1 has a job value of $200,000, which would require 2000 resource hours. Building Contract 2 has a job value of $350,000, and would also require 2000 resource hours.
Obvious answer right? Building Contact 2 with a revenue upside of $150,000.
Not necessarily. On taking a closer look at Building Contract 1, we find that is has the potential to extend for 12 months, worth $1.2 million if phase one performance criteria are met. Building Contract 2 does not offer this potential.
On assessing the job market, the business owner believes that a long term contract will yield more overall profit and stability, and so chooses Building Contact 1. In this scenario, the business owner has assessed the lower-paying initial job with potential for longer term stability and profitability as more valuable than the higher paying, one-off Building Contract 2. The benefits of Building Contract Two – higher short term revenue – become the Opportunity Cost.
Another alternative – overcoming resource scarcity
So that’s one way our business owner could look at the options available. What if they decided to see if they could do both? They cannot complete both contracts with standard business resources – hence the need to assess which is the most valuable option – but taking on both contracts would support their growth objectives.
In this scenario, the question for the business owner becomes: at what cost are the benefits of taking on Building Contract 2 still worthwhile? Because it will cost more to resource the contract than usual – for example, the business will need alternative short-term funding for materials and contractor salaries – the margin on the contact will be lower. Is the monetary upside worth the cost involved? Will the lower margins support growth objectives? What profit would be foregone by not taking on the contract?
By looking at what would be lost by not taking an opportunity, business owners can often find a solution to overcome resource scarcity at a cost that still makes sense. Of course, sometimes it is not viable or sensible to proceed, but by accurately assessing the Opportunity Cost, a more informed decision can be made. And hindsight can take a back seat.
If you are juggling resources and missing out on opportunities, consider contacting Fifo Capital for a complimentary discussion on the solutions available for your business.
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