Business and individuals all face opportunity costs. The opportunity cost calculations have a large amount of uncertainty and probability. However, opportunity cost assessments should limit to realistic alternatives that a business considers.
As an extreme example, gambling money on lottery tickets is a terrible use of capital. The near-certain 100 percent loss of capital doesn’t generate any assets, growth opportunities, customers, or cash flow. On the other hand, the unlikely win makes all other uses of funds a cost by comparison. This kind of perspective, while technically valid, is unrealistic. Here, the focus is on expanding the definition of opportunity costs. We will see how to identify them, and how to reduce opportunity costs for a business.
What Is the Opportunity Cost
Opportunity costs are foregone benefits, though they can be recouped. For example, spending money on advertising to attract more customers entails a different opportunity cost. This can be paying down business liabilities such as debt and buying more assets/inventory for business growth.
In the ideal scenario, the new customers gained through advertising will generate enough revenue to bay back those liabilities and finance assets/inventory for business growth. Recouping opportunity costs is not a promise. However, it depends on customer relationships, the market, generally prudent planning and skillful capital allocation.
Who Uses the Opportunity Cost
All businesses incur opportunity cost in some form, but it helps to identify what kinds of major costs each type of business faces.
- Startups are faced with opportunity costs based on how to generate publicity, good first impressions with customers, and initial sales. Financing and details of hiring are moot if there is scant revenue and no sense of opportunity for customers, prospective employees, or investors.
- Established small businesses must growth prospects with cost control and other financial management that can continue to attract investors.
- Large business use opportunity costs that entail the cost of going along with what worked before vs. branching out into new ventures and operations that may suck up crucial working capital and alienate a loyal customer base.
How to Use the Amount of Opportunity Costs
It is reasonable to suppose that enterprises in a weak market position or decision-makers with crippling information asymmetries might have the burden of inordinate opportunity costs. But the same problems can plaque even established industry leaders. Meaningful opportunity costs for large businesses and market makers may seem odd. But consider how Walmart’s domination in retail is now under serious threat from Amazon’s new business online sales model.
Walmart may decide to invest in similar cost-competitive online services or try a different revenue-boosting strategy through traditional retail. This incurs a hefty opportunity cost in terms of lost market share to Amazon. Also, other retailers will learn from Walmart’s failures without such capital investment. The result is an edge in terms of cash positions that can be leveraged for significant gain over the expensive lessons that Walmart’s learned and the missed opportunities. Though financial and risk analysis thrives on numeric information, it is difficult to quantify opportunity costs as they relate to things that didn’t happen but could have. As such, projected returns for various investments, even when adjusted for risk, can understate the full extent of a decision related to critical opportunity costs.
3 Ways to Reduce the Opportunity Cost to Help Your Business
Given the above information, reducing opportunity cost is prudent. Though judgment exercised in doing so is, of course, vulnerable to subjectivity and uncertainty, it is well within the purview of academic research, case studies, and business sense.
It helps to expand and grow within established core competencies
Multiple revenue streams should be diversified, as long as attempts to pursue such diversity don’t compromise the mission, strengths, and institutional knowledge of a given enterprise. Customers and investors recognize that no organization, product or service can do all things to everyone. Family Dollar doesn’t pursue lucrative advances in scram-jet propulsion, nor does Boeing dabble in discount consumer staples. These truths reflect the wisdom of staying within developed strengths when considering opportunity costs.
Investing capital is a great chance to knock down a high opportunity cost
Reduce such costs with likely behavior of key consumers in mind. Take for instance, small businesses that primarily rely on budget-friendly discounts and sales. They have to recognize that their customer base and revenues will shrink with rising unemployment more so than a trader in luxurious jewelry or precious metals. Online businesses who want to woo clicks and sales should focus heavily on loyalty programs and other membership perks. These should be above complicated speculation if they want to retain fickle internet users with ever-expanding electronic distractions.
Opportunity cost relies on what to pay off, on the cost control side
For example, secured and unsecured debt are two expenses many businesses deal with. Which to pay off, and how much and how frequently? You need to prioritize insecure debt since it carries a higher penalizing interest rate. However, consider that the opportunity cost of ignoring lower-rate secured debt is loss of the collateral assets if not paid enough. On the other hand, over-emphasis on secured debt entails the opportunity cost of overall larger expenses. This happens because unsecured unpaid principal accrues more interest over time.
Opportunity cost need not be a ball and chain on business growth. Opportunity costs vary with the type and size of a given enterprise and you can anticipate and control it to some extent. The uncertainty surrounding opportunity costs is not inordinately larger than the typical risk of any enterprise.
Minimizing opportunity cost is not a linear or simplistic process. Regarding loans, an optimal payment plan ensures that debt collateral is retained. Also, high interest on unsecured debt doesn’t get ahead of cash flow.
Your opinions on such costs are welcome in the comments or on Facebook.
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