Most business owners know how to calculate fixed costs—like rent and equipment—and variable costs— such as wages, utilities, materials, etc.— related to providing goods and services. But there is another kind of cost to consider when making business decisions: lost opportunity cost. While lost opportunity costs can sometimes include intangible factors that are harder to measure, that does not mean they are not real. Savvy business owners understand how to identify and measure them, and how to respond when they arise.
What is a lost opportunity cost?
As a business owner, you have to make frequent decisions about how to use finite resources. Any choice you make means diverting those resources in one direction instead of another. The choice to buy new equipment may mean you have less time to pay for additional employee training. The choice to take on one time-consuming project may come at the expense of taking on several important, but smaller, projects. Any decision, no matter how small, comes with some opportunity costs.
Imagine your company has the chance to make a large sale to a creditworthy customer. It would mean significant growth for your company, and it may lead to more sales of its size in the future. However, at the moment, you don’t have the working capital you’ll need to complete the sale. It would strain your resources to buy additional materials or pay for more employees, in addition to your existing costs, all before the customer pays you.
You could turn down the opportunity, losing out on the chance to realize growth for your business. Alternately, you can take on the opportunity by securing financing from your bank in the form of a loan or a line of credit.
How should I measure opportunity costs?
Whether you should decide to forgo the opportunity or secure financing to proceed with the opportunity depends on the potential profitability. If the amount the customer will pay is enough to cover the fixed and variable costs and the cost of financing the project, it might be a good opportunity. If it wouldn’t more than pay for all costs involved on your part, it’s probably not worth considering.
When weighing the value of a potential business opportunity, you should estimate financing cost in dollars, rather than percentage points (APR). Add this cost in dollars to the existing fixed and variable costs associated with the project. This will allow you to have a clearer picture of the potential value of this sale, or to quote the customer an appropriate amount so that you can turn a profit on the sale.
Minimizing the opportunity cost to your company
If your price will allow some adjustment, it’s possible to have your customer carry some or all of your financing cost by adding 2% to 3% to the cost of a project or job. If you can do that, you will likely be able to cover some or all of your financing costs. As long as your gross and net profit margins are in your target range, the decision to use financing to fund the growth in your business should be an easy one.
If you find that your company is starting to strain its working capital, think about the associated lost opportunity costs. Missing out on a large sale or project because you don’t have enough working capital can prevent you from fully realizing potential growth for your business. It may be worth your time to consider securing a loan or line of credit or other financing in order to accept valuable future opportunities.