In Economics, Opportunity Cost is defined as the cost of an opportunity forgone. It is about choices and is a basic lesson in Economics 101. You may dismiss this as you might not view yourself as a student of economics, but in most small businesses today, Opportunity Cost is usually one of the biggest “loss of profit” costs there is.
A classic example of opportunity cost might be as follows: You have 1 day in a particular city while away. You can either use the time for sightseeing or for visiting friends. If you use all the time for sightseeing, there will be no time for visiting. So the opportunity cost of sightseeing is not visiting your friends. This is a simplistic example. Opportunity cost scenarios can be a lot more complex.
There are endless instances of opportunity cost in a typical business. Business is a continual process that is characterised by compromises, judgement calls and trade-offs. In many of these situations, opportunity cost must be weighed against the day-to-day realities on the ground.
For most businesses situations today there are four main categories of Opportunity Cost you should consider:
- The Product Opportunity CostScenario:Customer asks you for a product you don’t sell. You don’t stock or supply it; you loose the 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.
- The Stock Opportunity CostScenario:Customer asks you for a product you do sell, but for some reason you don’t have stock. You loose the sale again. Here, good inventory management practises are what it takes to avoid this. Depending on your business, getting your inventory correct is not always easy and it may take some investment in systems to get this right. In certain (typically retail) situations the stock opportunity cost can manifest itself in a more complex way. Take the example of retail fashion. Incorrect buying, product delays and other causes can result in a retailer having too much stock of a line at the end of the season, with little prospect of sale. If this inventory cannot be converted back into cash, it may be very difficult to make sufficient purchases to satisfy the following seasons Open-To-Buy requirements. This could be an opportunity cost of disastrous proportions.
In examining opportunity cost in greater detail, where the choice is not just between A or B, opportunity cost typically are non-linear and become higher at the margins.
Courtesy wikibooks.org
In the diagram above, the difference in the cost of 5 or 6 computers, (a difference of 1) is 1 food unit. Whereas, when there are already 9 computers the cost of an additional computer is 3 food units. In other words the cost of an additional computer when there are already 9 is 3 times as much. How does this apply in business? If you are selling product simply by the unit and you run out of stock, you may lose one sale. If you are selling more complex products that have multiple components, then for the sake of not having a single component in stock, you may loose an order for an entire system.
- The Time Opportunity CostHow a business owner decides to use his time is hugely important. Have you ever stopped to consider the Opportunity Cost of your time? Lets take an old chestnut; the business owner who does his own bookkeeping. Bookkeeping is something that most people in business can do adequately competently if necessary and so, many do. The thought process behind this is “why should I take money out of my pocket to pay someone for a job that I can do adequately well; it wont take all that long!”. The Opportunity Cost here is as follows: As the Business Owner, one needs to analyse and understand what is the most valuable and important contribution he/she brings to the business. Invariably this is the ability to develop the business, promote important relationships, build and train the team, make the big sales, look for the next big opportunity etc. When you are operating in this mode, your time has a value of $100 – $2000 an hour, depending on the business. Bookkeeping is worth around $30-$60 and hour. Business owners who get their heads around this one start to make big strides.Then there is the simple time opportunity cost of procrastination. In many owner-managed businesses, anxiety and stress can lead to decision paralysis or inaction. At a future point this could cause a product or stock costs.
- The Knowledge Opportunity Cost. This is the most expensive and subtlest of all. There are opportunities all around us. What prevents us from taking them? Mostly, its knowledge. For example, the reason we don’t all make a killing on the stock exchange is because we lack the knowledge to do this. By investing in ones education in this field, you would put yourself in a position to make a whole lot of money.This is true of education in genera l and more specifically of business education. A large proportion of people in business either have had limited business education or their business education falls short of their present opportunity needs.Education may seem like a really blunt tool to use to be more successful in business; but it is the ultimate one. Does it take time and money to increase your knowledge? Absolutely! – but it infinitely beats the cost of being ignorant.
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.
