Your Greatest Expense: Opportunity Cost
- Published: 07/22/2014
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In life, we must make choices. And, these choices or tradeoffs have consequences. Some of these tradeoffs are obvious. For example, buy a new TV, and replacing the old lawn mower may have to wait awhile. Go to the Disney for vacation this year; forgo your usual trip to Myrtle Beach. If your son or daughter spends all of their allowance on a toy, they have no money left to buy candy. These trade-offs are obvious!
Other trade-offs, however, are not as obvious. For example, spend an hour watching TV instead of taking a walk and you’ve given up burning 202 additional calories (losing about two pounds per month). The consequence of this choice may show up later in the form of a serious medical condition. Stop making date night a priority in your relationship and you may be sowing the seeds of future dysfunction – and the consequences that follow.
Business & Opportunity Cost: In economics, these consequences or tradeoffs are called opportunity costs. Opportunity costs are opportunities lost because of the decisions we make. In other words, it’s what we gave up to get what we got. Considering opportunity cost is absolutely essential to ensure the best use of our limited resources. Unfortunately, however, it is all but ignored in traditional accounting, and it is often a realization that comes too late when business owners reflect on the reasons for their struggle, crisis, and failure.
Small Business’ Largest Cost: Although opportunity cost impacts businesses of all shapes and sizes, its consequences are disproportionately higher for small businesses. Why? There are two basis reasons:
- Like the majority of Americans who live paycheck-to-paycheck, most small businesses survive customer-to-customer and lack the ability to endure an unexpected expense or loss of income for very long. They do not possess the financial reserves of many larger businesses and this lack of reserves (capital) increases the financial impact of each lost opportunity.
- Small businesses often lack the manpower (talent and time) needed to serve current customers and run day-to-day operations, while recognizing (let alone taking advantage of) opportunities as they arrive. The result: Instead of growing, their business gets stuck in the Survival Stage - a perpetual state of financial struggle and stressful crisis.
Cost = Business Success: Although the opportunity cost faced by most small business owners can be measured in foregone customers, revenues and profits, it can also be measured in terms of time lost with friends and family, relationship-dysfunction, and stress-related illness. Unfortunately, these costs are the result of continually foregoing daily opportunities to achieve the very thing owners seek: Business Success.
Why do these owners fail to achieve Business Success? Two Reasons:
- As they get caught up in the busy-ness of day-to-day business, many important functions develop out of the owners’ habits and personality instead of intentionally developed procedures. This results in owners losing sight of what they are pursuing: Business Success. And,
- They fail to align their most valuable resource, TIME, with achieving the following definition of Business Success:
Business Success Definition: The definition of business success is simple and has four basic parts. A successful business is…
- An organization that efficiently and effectively;
- Makes current customers happy,
- Obtains new customers, and
- Creates a profit – generates more cash than it spends after paying the owner.
As simple as this definition may be, very few businesses measure their daily activities in light of this definition and waste precious hours on activities that may feel important - even urgent - but actually result in mediocrity and crisis.
Example - Opportunity Cost:
To illustrate the cost of failing to tie business activities to achieving success, let’s consider the opportunity cost faced by a single business owner, Kevin.
Kevin’s business repairs manufacturing equipment for companies throughout the region. Kevin’s four employees handle the repair work as he lands new clients and schedules jobs. The average repair job costs customers $7,000 and generates a gross profit of $1,500. Customers average 4 repair jobs each year. It generally takes Kevin 20 hours to find and secure a new client.
Unfortunately, however, Kevin has a problem that consistently draws his attention away from getting new customers: He has a problem getting paid for jobs that have been completed. As a result, Kevin spends a day and a half (12 hours) each month driving across the region to collect past-due invoices.
Opportunity Cost - Success Denied: The 12 hours per month, 144 hours per year, Kevin spends collecting money are gone forever and cannot be used to achieve success. As mentioned earlier, if it takes Kevin about 20 hours to secure a new client, he is trading over 7 new clients per year to deal with the crisis created by slow-paying customers.
What does this mean in terms of lost revenue and growth? Since the average customer uses his services four times per year, Kevin’s collection policy costs him 28 repair jobs per year - that’s $196,000 in annual sales growth and $42,000 increased profit! Kevin’s collection policy, a crisis-created policy initially born from Kevin’s tendency to deal with issues head-on has become a habit – actually an internal business procedure— that is actually costing him the opportunity to achieve true, life-changing success!
Common Problem: Kevin’s problem is not uncommon. It illustrates how a business owner’s informal policy (in Kevin’s case collections) can create a persistent and critical shortage of both cash and time. The crisis-creating policy could have been brought about by any number of things – untrained employees, administrative duties, unnecessary phone calls or prolonged meetings - anything that takes the owner’s focus away creating success. The result, however, is nearly always the same… the business struggles and drifts further away from achieving success. Unfortunately, because most success-usurping policies develop out of habit, few owners ever consider how much these habits, i.e., their policies, truly cost.
Solution: Once Kevin realized how much his day-and-a-half monthly money drive was costing his business, he became serious about redirecting his focus on success. First, he created a formal, written collection policy (a system) that included a small early payment discount and finance charges for late payment. Then, he hired and trained a part-time employee to operate his collection system. This new habit—or procedure – effectively put collections on auto-pilot and allowed Kevin to refocus his most valuable resource, TIME, on actually growing his business!
Ironic Policy Consequences: When Kevin introduced his new collection policy to customers, he was shocked by what he learned. Most of his customers were not slow paying on purpose – they had simply become so accustomed to his regular visits that they developed their own policy of paying him when he arrived. His informal collection policy had actually perpetuated the crisis he was attempting to resolve!
Take Away: Success is not an accident. Nor is it based on luck! Success is the product of continually identifying habits -– processes—, and redirecting and refining your focus on achieving a particular goal. Whether it’s improving a golf score, losing weight, or creating a prosperous business - success is a process. It requires critical evaluation of the way you utilize your most precision resource, time. It also requires the willingness to redirect activities to make sure you are using this resource to achieve business success. If you need any assistance achieving business success, please call our office at (304) 267-2594 to learn about upcoming seminars and classes.