|
Many years ago, I visited a business school I was considering and sat in on a class.
I arrived a few minutes early and introduced myself to the professor. He told me class would be getting started in two minutes. Then he handed me a copy of the case discussion for the day.
It was thick — clearly there was no time to read it. So I just gave it a quick scan. The essence of the case centered around whether the company in question should make or buy a particular part.
The case was overflowing with information and data. So much so, in fact, that as class got underway, I learned the students had worked in study groups the prior evening for about three hours, trying to come up with the answer.
Over the next 90 minutes,
I listened as the class debated the ins and outs of the make vs. buy decision, delving deep into the cost accounting specifics.
By the end, it was obvious most students believed the company should make the part.
I didn't… I thought they should buy it.
Why? Well with only two minutes of analysis time at my disposal (I didn't have time to get into the murky details!) and a freshly minted economics degree in hand, it seemed natural to me to view the dilemma though the lens of "opportunity cost."
The way I saw it,
it was less a question of the specific cost details of making the part than it was the broader issue of how else these same company resources could be used.
Happily (for me) the professor confirmed my point of view at the end.
What is Opportunity Cost?
Simply put, opportunity cost is
the cost of foregoing the next highest valued alternative use of a given resource.
In the business school case above, the cost to the company of making the part was the foregone profits of what the plant
could have
produced if it bought the part and made something else instead.
Opportunity cost is
a big picture means of looking at things and it's the essence of economics
— deciding how to rationalize opportunities. It comes down to determining the highest use and highest value of a given resource, whether that's time, money, production capacity, or something else.
Opportunity cost allows you to focus on and understand the essence of what the real decision is. And when you do that, 90% of "the facts" become irrelevant.
Two Critical Components
There are two critical components to opportunity cost analysis.
#1. Identify the constraint.
In the business school example, the constraint was machine time. During the pandemic, a manufacturing client of mine did not have the staff to produce all the orders in a reasonable period of time.
In this case, the critical constraint was people.
So, I helped my client understand the profitability of its products and customers by man hour of its key manufacturing lines. That meant taking into account the incremental profitability of each item and customer per unit sold
and
how fast the machine ran based on that particular product run (some products ran much faster than others).
Sometimes the critical constraint is not so obvious.
Many years ago, a division I was working in proposed a significant acquisition to senior management. By buying the company in question (which had two divisions related to my company's existing product lines), substantial shareholder value could be added. The company generated tremendous cash flow, so the company's cost of capital was very low. The cost of capital was used as a proxy for opportunity cost.
The division's analysis was solid and each stage approved the deal up the line. Then it reached the Chairman. He said no and for a very good cause: The organizational resources that would be consumed by fixing and growing this company could create
more
shareholder value doing something else.
The true constraint was not capital but organizational time and focus.
The opportunity simply wasn't big enough for the work required. In his view, we would end up foregoing bigger opportunities around the corner.
#2. Get the time frame right.
A classic opportunity cost time frame question is “spend or enjoy now” versus “spend more or enjoy more later.”
The opportunity cost of what you spend today is what you can spend later. In the business school example, the time frame was near term. Longer-term capacity could be added and machine time would not be a constraint. In the acquisition example above, the time frame was several years.
Time frame matters and you need to consider the nature of the decision to
get it right
. Many decisions are easily classified as either tactical (short term) or strategic (long term) in nature.
There is no right or wrong — the key is in understanding which type of decision you are looking at
and in taking clear and conscious action that takes into account the associated time frame.
A few tips…
-
If you make the same opportunity cost decision often,
invest in good data and put formal processes in place for the relevant decision.
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, or some other factor per unit of constraint. Profit per machine hour is an example. Then, have a formal reoccurring process to review profitability by whatever the relevant constraint is.
-
Look at the cost to eliminate the constraint.
Can capacity be increased and, if so, at what cost? Note that often the more intangible constraints
can’t
be eliminated or capacity increased, such as management focus in the earlier example.
-
Always keep in mind that
the bigger the opportunity the more likely the critical constraint is less obvious,
as in the acquisition example.
Final thoughts
The concept of opportunity costs is at the heart of economics.
It is also the key to many business decisions. Get the critical constraint and time frame right and your business will make better decisions.
|
