What are lost opportunity costs and how do I measure them?

August 15, 2011

Many business owners know how to calculate fixed and variable costs related to providing goods and services, but there is another kind of cost known as lost opportunity costs that should be considered when weighing business decisions.

Lost opportunity costs may not be recognized in Generally Accepted Accounting Principles (GAAP), but they are very real. Savvy business owners understand how to measure them and respond to them as they arise.

 

Scale of lost opportunity verses risk

Think of lost opportunity costs this way. If your company has an opportunity to make a sale to a credit worthy customer that will generate a net profit margin greater than the cost of financing the project or service, then the opportunity should be considered. If the opportunity can’t generate enough profit to pay fixed, variable, and financing costs than perhaps it shouldn't be considered.

When measuring the cost of lost opportunities, you should estimate the cost of financing an opportunity in dollars rather than percentage points (APR). By estimating the total dollars that it will take to finance a project or large increase in business then comparing then to the amount of net profit the service or product will generate you can compare apples to apples.

As the economy rebounds, companies that have not thrived during the recession will have a difficult time finding new inexpensive credit. It will likely take showing several years of profitable growth to regain the ability to find traditional bank financing.

In order to finance growth during the recovery, many companies will have to turn to non-traditional forms of financing like factoring and asset-based loans. Often times alternative financing sources cost more than traditional sources, but may be still worthwhile to use while your company is building net profits and retained earnings.

Commercial finance companies often charge a discount rate for providing working capital financing to a business. That rate is customarily charged on the funds employed by the borrower with a discount fee range of .9% for 30 days to as much as 3% for 30 days use of proceeds. If your price will allow some adjustment to it, one of the ways to have your customer carry some or all of your financing cost is to add 2% to 3% the cost of a project or job. If you can do that you will be able to cover some or all of your financing costs and as long as your gross and net profit margins are in your target range, the decision to use an alternative commercial finance company is easy.

If you find that your company is starting to strain its working capital, think about opportunity costs. Either you can turn down a sale or project because you don’t have enough working capital or you can compute the opportunity costs. If they opportunity costs are less than the profit you will earn on the business, the alternative financing might be worthwhile.

Topics: Featured, Blog Posts, Accounting & Finance

Ed Lette

Business Bank of Texas

Ed Lette is founder, president and chief executive officer of Business Bank of Texas, N.A. and serves as chairman on the company’s Board of Directors. Serving as a licensed CPA since 1983, Ed’s extensive experience in the banking industry has led him to become the founding president of four national bank charters including Business Bank of Texas, N.A., and the chief financial officer of five national banks during his 45 year career. Ed serves as director of the Texas Bankers Association District 4, chairman of the Executive Advisory Council to the School of Business at Texas Lutheran University, and is a life member of the Texas Association of Business.
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