The Most Important and Most Misunderstood Concept in Business - Opportunity Cost

 The term opportunity cost is thrown around a lot in business. However, my experience, through observation, is very few people truly understand it. My intent in this blog post is to try to explain why you should always consider opportunity cost in every decision you make. 

Let's start by defining the term using the economic idea:

"Opportunity Cost is the potential benefits an individual, investor or business misses out on when choosing one alternative over another" 

I had a conversation with a person today who said they were saving a lot of money by not hiring a house cleaner. My mind immediately went to this concept, so I asked the person, "How much is your time worth"? I had a general idea of their income and, more importantly, their income generating capability so I explained to them not hiring house cleaner was costing them money! The next best alternative for their time (i.e., working) generated more income than cleaning their home themselves. Voila! Opportunity cost!

If the person responds, as some do, that they make no more money by working more (Strictly salary), therefore the concept does not apply, I ask then a follow on question. 

If you paid me $100 and I was able to give you 3 more hours with your kids would you pay me? The answer is almost always yes. Once again, the value of those three hours is $100 (likely they would have paid even more) and the cost of a house keeper, at $20 per hour, means it costs $60 to clean the house, so it is clear the person makes money by hiring a house keeper. They get 3 hours with their kids for $60 when they already told me they would pay $100 or more. 

Now, let's apply this to business. You hear a lot in business how strategy is as much about what you will not do as what you will do yet companies can't seem to turn anything off. Why is this so important? The answer is simple. In an environment of scarce resources (which I dare say every company has scarcity) you have to assume that every dollar and every minute spent doing one thing is a dollar or a minute not spent doing something else (see kids and housekeeping analogy above). If you assume that is true then where is the analysis of what the dollar or minute could be doing?

The concept of NPV (Net Present Value) tries to get at this. Theoretically, any project with a positive NPV should be funded. However, that assumes unlimited resources. Given that we know resources are limited NPV will tell you that the project with the highest NPV should be funded and the other should not. This is the opportunity cost. If you choose the lower NPV project then you would be forgoing the more lucrative one. I found the conclusion at Sapling to be the clearest:

"If both projects have a positive NPV, compare the NPV figures. Whichever project has the higher NPV is the more profitable and should be your first priority. Doing both projects is fine, since both will be profitable, but if you can do only one then go with the higher-NPV project. 

Some may say "the resources are different so do both" but that is very rarely true. Almost always resources are fungible or, you can relieve some resources and acquire the ones you need. Time, of course, is your most valuable resource and that is completely fungible. 

In his book Good Profit by Charles Koch Mr. Koch describes this concept and uses it throughout the book. He says:

"The true cost of any activity is the highest-value activity forgone [italics and bold are mine] - that is, the opportunity cost. This is the methodology I encourage employees to use in making decisions, and I strive to practice what I preach."

So, the next time someone does a project ask them, "what activity are you forgoing to do what you are doing and what is the value of that forgone activity"?  If they cannot answer that question, then they have not done good project analysis and they are not allocating scarce resources efficiently. 

I think this is a core concept whether you are in supply chain or any other part of the business and what I find is the businesses that are highly successful are able to prioritize, using the concept of opportunity cost, and focus all their resources on the few incredibly high value projects. They do not spread their resources so thin that no high value resource is starved. 

Many of you know I served in the military and we called this the "Principle of The Concentration of Forces". The definition is:

"The ability to apply sufficient military force at the right place at the right time and in a manner that assures the achievement of the desired and decisive results"

Let's all agree to learn from the concept of opportunity cost and its military counterpart - concentration of forces.