Opportunity costs

opportunity-cost

When I talk with founders about the costs of their business, they virtually all focus on financial costs. And of course financial costs – salaries, benefits, rent, marketing expenses, etc. – are critical in any startup business.  These are all operating costs.

Less frequently do founders take into account capital outlay costs, unless their business requires the purchase of expensive lab or fabrication equipment.  These are the fixed, one-time expenses, incurred by the firm.

But there are two other types of costs that are far less apparent, far less often discussed or even recognized: transaction costs and opportunity costs.

I wrote about the six types of transaction costs in m  Beware of Transaction Costs, Especially with B2B Customers.

However, recent meetings with founders have caused me to bring up the issue of opportunity costs with them.

The short and simple definition of opportunity cost is the loss of potential gain from other alternatives when one alternative is chosen. More specifically, it is when these opportunities are mutually exclusive. When you can either have your cake or eat it, but not both.

Opportunity costs are most evident in service firms where allocating staff resources is perhaps the most important decision made by the firm’s executives. If staff are allocated to serve client A they thus may not be available to service client B, thus losing client B’s business, which actually could be more lucrative.

From Wikipedia:

In microeconomic theory, the opportunity cost of a choice is the value (not a benefit) of the choice of a best alternative lost while making a decision. A choice needs to be made between several mutually exclusive alternatives. Assuming the best choice is made, it is the “cost” incurred by not enjoying the benefit that would have been had by taking the second best available choice.[1] The New Oxford American Dictionary defines it as “the loss of potential gain from other alternatives when one alternative is chosen.

Wikipedia goes on to describe the two components of opportunity cost: explicit and implicit:

Explicit costs are opportunity costs that involve direct monetary payment by producers.

Implicit costs (also called implied, imputed or notional costs) are the opportunity costs that are not reflected in cash outflow but implied by the failure of the firm to allocate its existing (owned) resources, or factors of production to the best alternative use.

I look at opportunity costs somewhat differently. There are financial costs, such as the explicit cost defined above, but also strategic costs and benefits. For example, in addition to immediate and direct financial benefit of choice A there could be strategic benefits from choice B:

  • Brand awareness and marketing value – Client B may be a big name. Working with them could well attract other “big name clients” even if the fee paid is less.
  • Repeat businessLifetime customer value is often driven by repeat business. A
    one-time engagement may not be worth it if it prevents the firm from taking on a client with strong potential for repeat business.
  • Learning – startups are learning machines. Your firm may learn a lot more of value from working with Client B than Client A.
  • Tool development – building tools is a competitive advantage of many high tech companies. If project B can result in building more or different tools for the firm that project may be a better choice. Even better if this tool development is financed by a customer!
  • Leverage – If the work for Client A is totally de novo, but the work for Client B can be done by reusing or replicating work that’s already been done, the strategic advantage may go to client or project B.

Choices of where to allocate your firm’s resources, whether to a specific product, project, service or client need to be made in the context of all three types of costs and benefits: financial, transactional, and opportunity – otherwise, there is substantial risk the decision will be sub-optimal in the short term, the long term or both.

Developing decision support tools and frameworks that take into account all costs in resource allocation decisions can streamline the process and improve the odds that the decisions made will be the correct ones.

 

 

 

Author: Mentorphile

Mentor, coach, and advisor to entrepreneurs, small businesses, and non-profit organizations. General manager with significant experience in both for-profit and non-profit organizations. Focus on media and information. On founding team of four venture-backed companies. Currently Chairman of Popsleuth, Inc., maker of the Endorfyn app for keeping fans updated on new stuff from their favorite artists.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s