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 that 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 that 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 that most students believed the company should make the part. I didn't - I thought that 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.
If, for example, you're a high school athlete with the option of playing just one spring sport and you choose baseball instead of lacrosse, your opportunity cost is not playing lacrosse.
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.
With that in mind, here are five keys to leveraging the power of this concept:
- Determine the true constraining resource.
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.
- Analyze and understand the economic impact of the competing uses.
Once the true constraining resource has been identified, you need to know the value of the various alternative uses of the constrained resource. Sometimes the alternative value is easy to ascertain and sometimes not.
Let's say you're choosing which of three prospective clients to pursue - calculating the product margin alone may be incomplete. If there's variation in the cost of servicing the prospects, for example, you'll need to fine-tune your numbers to get a true value of the relative options.
- Determine the cost of obtaining more of the constraining resource; decide if more should be had.
In the business school example, management would want to know whether relevant production capacity could be increased, at what cost and how fast. If all that was necessary to increase production capacity, for example, was to add another employee and drop a motor onto the line, making the part might be a better alternative.
If a production line would have to shut down for an extended time, the lost production would make the capacity expansion expensive. As for expanding the breadth of organization focus in the acquisition example, that is an oxymoron.
- Determine the right timeframe to consider when making the decision.
Is this a short-term decision and therefore increasing the constrained resource won't matter, or does the decision have longer term consequences? Will the values of the competing alternatives change over time? How fast can the constrained resource be increased?
The timeframe can affect how the analysis is done. If the decision is short term in nature, a focus on contribution and variable costs is important. If the decision is long term in nature, full costs may need to be considered.
- Don't waste time and effort in data swamps and superfluous analysis.
Focus analysis and management time on identifying the true constraint. Then understand the values of alternative uses of the constrained resource. Lots of good opportunities are missed because decision-makers spend too much time analyzing irrelevant data. Worthwhile projects may die from drawn out, hard-to-complete analyses that don't matter.
In the business case example, students spent three hours prior to class and an hour and a half in class analyzing and discussing data and issues that were irrelevant to the decision at hand. How much time does your organization waste on irrelevant analysis?
Opportunity cost is a powerful concept, but one that unfortunately, is often overlooked. Keep these five key points in mind as you evaluate and move forward on your next set of challenges.