Earlier this month, a client and I were talking to their current lender — a relatively expensive, cash flow lender. I am helping the client refinance with cheaper debt. We asked the current lender to stay in with a term loan that was smaller than the existing loan. The lender said no.
Because of the increase in merger and acquisition activity that is happening to beat the expected increase in capital gains tax, the lender said it could not devote the time to do the transaction. As it is, they are struggling to consider other opportunities in front of them that are much more lucrative. In other words, the lender decided the opportunity cost, in terms of the firm’s time, was too high.
I have talked about
opportunity cost before. It is the cost of foregoing the next highest valued alternative use of a given resource.
Today’s newsletter, while also about opportunity cost, is more specific: it is about identifying the critical constraints that create opportunity cost in the first place. If that lender, for example, had the entire organization trying to find business rather than close it, the organization’s time wouldn’t be a constraint.
So, look for where the resources of any kind are limited. In general, there are four types of constraints to consider: known and routine; known and transitory; easily known, major, and sporadic; and not so obvious, but major.
#1. Known and Routine Constraints.
Most of these involve time, and in some cases, supply. For example, a company’s customer service capacity in a call center is fixed at any point in time. If there is a surge in calls beyond the center’s capacity, there is wait time for customers, causing dissatisfaction and, potentially, a lost customer. So, customer frustration and the risk of losing a customer is the opportunity cost of limited call center capacity.
Companies minimize the opportunity cost of losing or irritating customers by doing such things as answering the calls of the most profitable customers first, or giving airline frequent fliers preferential boarding. The distinguishing aspect of known and routine constraints is that processes, systems, and so forth can be put in place to minimize the cost of that constraint.
#2. Known and Transitory Constraints.
These are the same as above, however they are temporary and sporadic. Examples today include raw material shortages, shortages of outbound freight (whether in the form of truck drivers, rail cars, or shipping containers) and, for many industries, people.
Here, existing processes, etc., that could minimize opportunity cost, usually don’t exist. And that is the challenge. As a result, a lot of company time is exhausted trying to find more of what is needed, to remove the constraint.
That’s important. But often not enough time is spent deciding what gets the now-precious resource, whether that’s customers, products, parts, or something else. And the data may not exist to accurately assess opportunity cost.
#3. Easily Known, Major, and Sporadic Constraints.
These are the same as known and transitory constraints, except they are major, perhaps even existential (i.e., all-hands-on-deck events). For example, if your sole manufacturing facility goes offline for whatever reason, and nowhere close to enough outside capacity can be bought or rented, then the situation is super critical.
In my world, cash or liquidity is often an unexpected constraint, so not all bills will be paid when due. A vendor’s reaction to non-payment is the opportunity cost of paying a different vendor, lender, etc.
#4. Not Obvious, But Major Constraints.
Managing these types of constraints is — or should be — a key skill of CEOs, general managers, Board members, and executive staff. That’s because identifying these constraints is less a function of skill than of experience and judgement.
Let me repeat an old story…
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 and capital was, therefore, not a constraint.
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 reason: The organizational resources that would be consumed by fixing and growing this company would be put to better use (i.e., create more shareholder value) by doing something else.
In other words, the opportunity simply wasn't great enough for the work required. In his view, we would end up foregoing bigger opportunities around the corner. Here, the true constraint was not capital but organizational time and focus.
A few tips on identifying constraints…
Have processes, systems, and so forth in place for routine constraints.
That also means having the information in place to identify where the costs and opportunities lie. For example, if a company wants its most profitable customers to jump to the front of a customer service queue, that company must first possess a way to measure customer profitability.
Determine the appropriate timeframe for 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.
Rely on experience and judgment.
Understanding critical constraints is vital and a key to maximizing profitability in any organization. When they are not obvious, experience and judgement are particularly important in identifying and managing these. This is how most hidden critical constraints are found.
Conclusion
As I have written before, opportunity cost is a
big picture means of looking at things.
It comes down to determining the highest use and highest value of a limited resource, whether that's time, money, production capacity, or something else.
Organizations that understand the impact that critical constraints have on opportunity cost are well positioned to make reasoned, informed business decisions as tradeoffs inevitably arise.
