Opportunity cost is one of the most basic and important concepts in decision making. In short, it describes the cost of foregoing one thing by choosing something else. For example, if a high school athlete plays football, he can’t
also participate in cross country running, as both seasons occur in the fall.
When it comes to making wise opportunity cost decisions,
it’s essential to identify the constraint(s) involved. One needs to know what these are and their value, what their alternative uses may be, how the constraint(s) may be most effectively removed and at what cost and speed.
In all cases,
opportunity cost is the value of the
most lucrative
alternative.
Factors to consider…
Some constraints are obvious. These include mutually exclusive options, such as in the “football vs. cross country” decision. In some cases, there are limits on a resource, such as time. In manufacturing, for example, where time is often expressed in terms of capacity, equipment may only be capable of producing so many widgets per hour, with a fixed limit on the hours a machine can run.
Other constraints are more obscure. In
a previous newsletter on a related topic, I shared the example of the Kraft Foods Chairman who declined to pursue a financially attractive acquisition because the acquisition would have taken the company’s attention away from its existing brands. Here, the constraint was management time and focus.
When it comes to determining
the value of what is forgone, there can be quite a bit of variation in our ability to attach a specific dollar amount. In the case of a given machine’s output capacity, it is possible to make a fairly precise calculation of the profit lost by choosing to produce one product over another. In the Kraft Foods example, on the other hand, the costs simply aren’t quantifiable.
If feasible,
try to determine what it would cost to remove a given constraint. How much is involved in adding another production line, for example? Or, what would it cost to add another shift, considering the time required to hire and train those who would be needed? In some cases, the costs of a constraint are adjustable — incurring overtime, is a common example.
In all constraint-removal calculations,
just make sure, first, that all products, etc., involved are sufficiently profitable to
justify
the overtime or otherwise more expensive capacity addition. Otherwise, from an opportunity cost perspective, drop the low contribution business.
For example, when I was in the foodservice distribution business, three of our four locations were strung, East to West, across Massachusetts and into New York State — Greater Boston, Greater Springfield and Greater Albany. We had a new general manager who was a “grow sales” guy. He wanted to expand our smallest location (outside of Springfield), by building a new, larger operation in Central Massachusetts. Both Springfield and Boston were at capacity. Unfortunately, every time I did the analysis, there was no way to do this and get an acceptable return on capital.
I dug deeper and found that the Springfield location had the
lowest profit contribution (by any measure) of these three locations. I recommend its closure along with pushing the business into Boston and Albany. Further, to gain capacity in Boston, I recommended dropping some large accounts that were marginally profitable.
A few tips…
If you make the same opportunity cost decision often, invest in good data.
For example, if you have a manufacturing operation running at capacity, know the profit contribution per hour of the various things that operation does. This might be profit contribution, revenue minus variable costs, etc., per unit of constraint. Profit per machine hour is an example.
Put formal processes in place for reoccurring opportunity cost decisions.
For a manufacturer, this can include periodic reviews of parts made in-house vs. purchased. In the foodservice example above, our warehouses were at physical capacity, so we had periodic processes to review the items we carried. This analysis may also involve demand or sales forecasting. That way, you can look ahead and see if you will be capacity-constrained, and so drop low margin business now, before hitting the constraint.
In larger companies, consider opportunity costs in annual and multi-year planning processes.
When I worked at Kraft Foods, we wanted to deliver leading financial performance relative to our competitors, in terms of return on equity (ROE) and earnings per share (EPS) growth. To develop our ROE and EPS targets, we began the annual planning process by assessing what our competitors could deliver financially. Next, we looked at the alternative uses of cash flow and earnings, as those were realistically constrained in the following year. That led to a series of decisions regarding how large a dividend to pay, how many shares to buy back, and what earnings we had to deliver.
The resulting earnings target then became the constraint. From there, we cooperatively decided which businesses to grow, milk or maintain, “investing” earnings accordingly. Much of the annual plan process is really a series of opportunity cost decisions, something we tackled explicitly.
When looking at the value of the alternative, make sure to use the correct economic perspective.
In the foodservice warehouse product review, we looked at profit and contribution per cubic foot of “picking space.” When looking at a capacity-constrained machine or production line, we looked at contribution per machine hour.
Remember that in many instances, some of the choices aren’t quantifiable at all.
This includes things like “company focus” or the preference for playing football instead of running cross country.
Final thoughts
Many critical business decisions are opportunity cost decisions in disguise. Make sure you identify them properly, evaluate their constraints thoroughly, and analyze them correctly.
