Opportunity costs represent the money you didn’t make through a different decision. Unfortunately, firms often either don’t consider the opportunity cost of their decisions or conduct a poor evaluation, resulting in reduced performance because our accounting systems fail to consider opportunity costs and too little effort goes into calculating anticipated profit from alternative decisions. Opportunity cost miscalculations hurt your bottom line.
Above, you see an example of opportunity costs we can all related to since we inherently make similar decisions every day — to buy one product versus another or to forgo purchases in favor of saving. For instance, that $6 Starbucks every morning comes to nearly $3000 every year. Thus, the opportunity cost of that daily coffee is the same as a simple vacation every year. Is that a wise tradeoff? It depends on your desires, so there’s no one clear answer.
Opportunity cost miscalculations: An example
Now, imagine you’re an organization faced with an important decision — say whether to introduce a new product or not. You’re facing serious uncertainty in terms of both your potential profits but also in terms of costs you’ll likely encounter. You don’t know what will happen in the future, which creates uncertainty that makes your calculations much harder.
That uncertainty creates a big problem for your organization. All things being equal, a firm prefers more certainty to uncertainty. Hence, big problem is that you don’t face uncertainty when it comes to sticking to your original product line, thus rejecting the opportunity represented by a new product reduces uncertainty. This is the beginning of opportunity cost miscalculations, avoiding uncertainty. Below, you can see Ansoff’s Matrix, a way of identifying opportunities for expansion that inherently expresses uncertainty as reflected by experience in product markets or consumer markets.
Before you can do any calculations, you must forecast the costs and potential sales. To avoid opportunity cost miscalculations, you also need to forecast trends in the industry and that’s what separates this type of analysis from the common practice of making decisions based solely on profitability. Opportunities detest a void so, if an opportunity exists, someone will take advantage of the opportunity. For instance, if there’s demand for a new product or a modification of an existing product you produce and you DON’T make the change, a competitor will jump into the void and take money that you might have earned had you made a positive decision about the product opportunity.
We have a specific name for a situation when you fail to recognize an opportunity; marketing myopia (or shortsightedness). A classic example used by Theodore Levitt in his original paper on the subject was the railroad industry. Many of today’s wealthiest families owe their start to the railroads; men like the Carnegies, for instance. With the advent of affordable automobiles, courtesy of Henry Ford, rail travel lost its appeal. It was noisy, sometimes crowded, and limited in reaching your destination when you wanted, while a car was more flexible, less crowded, and less noisy. Because railroad companies chose to fight the expansion of the car (and the building of public roads that supported their growth) instead of recognizing the automobile was here to stay and adapt their business model to the new reality, the railroads went bankrupt. Without a federal bailout, we would have no rail system. Using the bailout money, the railroads did what they should have done all along; transform to carry cargo instead of passengers. Thus, the opportunity cost miscalculations made by the railroads bankrupted them to the point where public funds were necessary to keep this vital industry alive.
Of course, determining inputs to make effective decisions isn’t easy and the less experience you have in that market, the harder it is to determine inputs (recall the Ansoff’s Matrix presented earlier. By building a prototype, you can estimate necessary costs, one of the many reasons why agile is the new standard for product development.
Determining potential sales is much more challenging. You must involve prospective customers, internal sources such as your salesforce, and economists to help with these predictions. You also need economists and others with the skills necessary to help forecast the future of the industry. Fortunately, a host of experts publish reports to help make these forecasts.
Tools to avoid opportunity cost miscalculations
Below, we discuss a couple of tools to reduce opportunity cost miscalculations using the example of adding a new product to your product line. Of course, you can use the same tools for any type of financial decision you face by simply adjusting the elements used to match those faced in your context. Also, reflect that these tools aren’t mutually exclusive and the best decisions come from using multiple tools.
Using break-even to reduce opportunity cost miscalculations
First, you must calculate the break-even value for your existing products. The formula for break-even is Fixed costs/ (Price per unit –Variable costs per unit); resulting in the number of units you must sell to break even. You can easily transform this into a break-even sales volume by multiplying the number of units you need to sell by the price of each unit. When you graph break-even, it looks like this:
Starting with break-even, you can play some powerful what-if games. For instance, what if I drop my price by 10%? Or what if I find a different supplier and reduce my variable cost per unit by $10? Using break-even analysis, I can figure out the new break-even when I produce my new product as well as my existing product by calculating break-even for each product separately.
Sensitivity analysis helps overcome uncertainty in making decisions to lead you toward the “right” decision. As you can see in the example below, the technique involves estimating costs and revenue using both pessimistic and optimistic assessments. NPV stands for net present value, a financial assessment that takes into consideration that money in the future isn’t as valuable as money today. If you’re really interested, you can see this post for more insights on how NPV is calculated and why it’s the best way to evaluate decisions that impact future profits.
Note that only in the most pessimistic scenario does the company face a loss of income.
You can combine sensitivity analysis with break-even analysis to determine whether you hit break-even in all scenarios
In some cases, introducing a new product, while advantageous for capturing a new market or making your existing customers more loyal to your brand, might cut into your sales for an existing product. We call this cannibalization. To effectively calculate potential profits, you must consider both the profits you get from the new product while subtracting the lost sales of your existing product.
While making calculations of cannibalization seem overly complex, they’re really fairly simple. Below, you can see a visual depiction of the calculation and if you click on the source link, you can find a very detailed strategy for making this calculation.
Why opportunity cost miscalculations are so rampant
As I mentioned at the beginning, many businesses do a terrible job of calculating opportunity costs. There are several reasons behind these miscalculations, including:
- Our accounting systems aren’t set up to make this calculation; they do a better job of calculating real costs and revenue
- Political forces within the organization favor the status quo so it’s easy to dismiss opportunities by overestimating costs and underestimating revenue
- Opportunity is a strategic discipline and often financial calculations are done by finance and accounting, which aren’t strategically trained
- Uncertainty makes everyone a little nervous, so it’s easy to avoid making decisions that increase uncertainty
- Organizations retain and promote managers who deliver revenue making it risky to one’s career to go out on a limb for something new while maintaining the status quo often results in greater rewards. For instance, there’s an old saying that “no one ever got fired for buying IBM” and we know that, as the computer world shifted to personal computers, buying IBM was a mistake that too many IT managers clung to for too long.
Solutions for making better decisions
The obvious solution for making better decisions is to enforce rigorous opportunity cost calculations for each set of decisions; comparing both prior costs and sales with anticipated costs and sales for EACH decision under consideration. That’s easier said than done; however, as you must expend a significant effort to make forecasts, especially with respect to anticipated changes in the external environment, including competitor responses and economic conditions like consumer confidence and wages.
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