In my last article, I talked about the importance of knowing who you are and what you want in your personal life to help guide the strategic direction of your business. Echoing the advice of Michael Porter, I suggested every decision be weighed against whether or not the choice takes you closer to or further from your vision for the future. But what if there are two choices that both take you towards your vision? How do you evaluate the benefits of one choice over the benefits of the other?
It is easy for business owners to suffer from indecisiveness. Every day, there are hundreds of decisions to make. Most of these decisions are relatively small and the impact of making a wrong decision is not significant. Because the consequences are simple to understand, your decisions are made quickly. Your choices become more challenging as the consequences of each choice become more complex. With everything that is going on in your business, you struggle to find sufficient time to evaluate bigger, complex choices.
There are many approaches to evaluating your choices as a business owner, and the purpose of this article is to introduce you to one more that’s fairly quick and easy to apply to choices of similar risk. It is called Opportunity Cost, and you should think of it as another tool in your professional toolkit to help you overcome decision paralysis.
“There are no solutions, only trade-offs”
– Thomas Sowell
I was introduced to Opportunity Cost during a managerial economics course early on in the program. As the professor explained, opportunity cost refers to the missed benefit of choosing one action over another. It equals that which you give up in order to get something else. It is important to evaluate not only the explicit costs like money but also the implicit costs like opportunity cost. While accountants are only concerned with explicit costs, economists are concerned with both explicit and implicit costs, and so should you when you are making strategic decisions.
Opportunity Cost = (Return of the Best Foregone Option) – (Return on Chosen Option)
For example, let’s say I own a company called Karl’s Curtains, where I produce and sell a range of beautiful, high-quality curtains using locally sourced fabric. Business is going well and I have accumulated $10,000 in a cash account above and beyond what I need to cover operating expenses. I want my money to work for me and I do some research to figure out what investment options will provide the best return. Two options come up: invest in the stock market for an expected annual return of 10%, or buy new sewing equipment that is expected to generate an additional 6% return annually. The opportunity cost of choosing the stock market over the equipment, (10% – 6%) equals 4%. In other words, I would give up the opportunity to earn a 4% higher return by choosing to invest in new equipment.
Based on this logic, let’s say I make the choice to invest in the stock market. Unfortunately, a global pandemic sends global markets into a recession and at the end of the year, the return on my investment is 0%. The opportunity cost of choosing to invest in the stock market instead of the new equipment (6%-0%) is 6%.
This outcome raises the importance of evaluating the risk of your choices as well as their expected benefits. It is important to compare options that have a similar risk in order to avoid a misleading calculation. Fixed income investments like treasury bills and bonds have extremely low risk, while stocks (equities) are much riskier, so it does not make sense to use opportunity cost when evaluating these choices.
One of the greatest implicit costs associated with opportunity cost is time. There are only 24 hours in a day and 365 days in a year. Our time is finite – we won’t live forever. The older we get and the more priorities we have, the more apparently valuable our time becomes. Understanding opportunity cost will help you make choices that use your time wisely.