There’s Always a Tradeoff! – Opportunity Cost

decisionsOne of the most basic functions that professionals perform is the decision to move forward with a project, investment or basic activity. Generally, the decision is framed in a simple question; do the anticipated benefits of the action exceed the expected costs? While that calculation provides a basic notion of the value of the action, it leaves out an important element. The concept of opportunity cost adds the idea of assessing the value of potential alternative actions to the equation. By utilizing this concept, you can make decisions that are more valuable and utilize the scarce resources of your enterprise more effectively.

The term opportunity cost was coined by the Austrian economist Friedrich von Wieser in his 1889 work, Der natürliche Wert (Natural Value) . However, the concept itself was first described by the French economist and philosopher, Frederic Bastiat. In his famous 1850 essay, What is Seen and What Is Not Seen, Bastiat described how the value of an activity could not be judged in a vacuum. He used a parable involving a broken store window, to show how expending resources on a given activity prevented the accomplishment of other activities. In the story, he showed how the replacement of the window, while benefiting the glazier, precluded the shopkeeper from spending the money on other, more useful items. Bastiat’s parable was a clever and vivid illustration of opportunity cost.

As Bastiat described in his essay, people tend to concentrate on the visible and tangible costs and results of an activity. Opportunity costs, however, are typically abstract, “in the future” and obscure elements of the decision making process. Because of this, opportunity cost remains a misunderstood and underutilized idea in the professional workplace.

Opportunity cost is a specific component of the total cost of an action. Many simple cost models only look at the direct costs of the preferred action (e.g. purchase price). Opportunity cost looks at the lost “opportunity” that would have been achieved by the next most desirable alternative action. It’s easy to see in the form of a few examples:

Example – Activity Decision – Utility Only

John is a college student who is making plans for Friday night. He decides to go to dinner with his Mom who is in town for the weekend. His choice precludes him from attending his school’s basketball game that evening. The opportunity cost of John’s dinner is the utility (or subjective personal value) he would have gotten from attending the basketball game that he will now miss.

Example – Lost financial opportunity

John has decided to go to graduate school. He estimates it will cost him $100,000 for the 2-year program. His second choice would have been to accept a trainee position that would have paid him $35,000 per year. His opportunity cost to go to graduate school would be $70,000 (2 * 35,000). His true total cost of attending graduate school would be the basic cost of $100,000 plus the $70,000 opportunity cost (total $170,000).

Example – Production Alternatives (non-monetary)

John has created a side business in his dorm. He produces novelty t-shirts and sweatshirts that he sells on campus. In his spare time each week he can produce either 10 t-shirts or 5 sweatshirts. The opportunity cost of producing 1 sweatshirt is 2 t-shirts. The opportunity cost of producing 1 t-shirt is 1/2 sweatshirts.

Example – Cost of Capital

John is buying a new car for $30,000. If he takes out a 5-year loan on the vehicle, it will have a total cost of $35,000. He could use cash available in his trust fund instead of taking out the loan. The trust fund currently pays him interest of $2,000 per year (we’ll ignore compounding for simplicities sake). If he uses the money from his trust fund, the opportunity cost will be $10,000 ($2,000 per year of lost interest for 5 years). Therefore, his total cost of buying the car with trust fund money is $40,000 ($30,000 purchase price plus $10,000 opportunity cost. He could use this analysis to see that taking out the loan would be, overall, a cheaper purchase option.

Complex Multi-Factor Decision with Financial Costs and Utility

John is faced with the same decision he had in the first example. His Mom is in town and would like to have dinner with him. However, this time, John decides to attend his school’s basketball game, as it is the final game of the season. Let’s look at a variety of possible elements that represent the opportunity cost of this decision:

  • He won’t experience the enjoyment of the planned dinner with his Mom
  • He will feel guilty about canceling at the last second
  • He will feel obligated to make a costly unplanned trip home the following weekend and treat his Mom to dinner
  • Because he will need to go home the following weekend, he will miss his frat’s big bash

Now let’s take the concept of opportunity cost and apply it to the workplace. Your department is faced with an interesting decision. It needs to implement some new capabilities for its mobile app to stay current with the competition. There is significant pressure from key business units to get these upgrades completed before the end of the year. Unfortunately, doing this project will require the use of your best engineers. Those engineers are also needed to remediate some regulatory findings from a key audit performed last year. If the engineers are directed to the mobile app project, the remediation effort will not meet the year-end deadline imposed by the regulators. The opportunity cost of moving forward with the mobile app project would include:

  • The fine imposed by the regulators
  • The reputational damage to the firm resulting from the regulator’s public decrees
  • The risk created by not closing the control gaps in the audit
  • The damage to the relationship with the auditors

So, to assess the total cost of doing the project, one would need to compute the direct projects costs (labor, hardware, software) and add on the opportunity costs. Note: Soft costs, such as reputational damage, are notoriously difficult to assess. That shouldn’t exclude them from the evaluation process, as they are real costs to the organization.

The next time you’re faced with an important decision, make sure you properly weigh your alternatives. Looking only at the net value of your immediate choice ignores the “costs” of not being able to undertake other actions.

 

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