Opportunity Cost: The Hidden Drain on Profit

Posted on

When a business owner looks at a Profit & Loss Statement it’s pretty clear which items impact the cost of doing business: payroll; rent; utilities; purchase price of inventory; etc.

What’s more difficult to see is what accountants and business consultants call “Opportunity Costs.” The World English Dictionary defines opportunity cost as: “the money or other benefits lost when pursuing a particular course of action instead of a mutually-exclusive alternative.” In other words, if you decide to pursue Option B, you lose any benefit that would have accrued from Options A or C.

As an executive or owner, you want to minimize Opportunity Costs. You do so by assessing the benefits and down side for EACH of the options before you. This enables you to get a clear picture of each possibility and empowers you to select the option that best satisfies your immediate (and possibly mid-term) needs. Once that decision is made, move forward.

For some reason, when it comes to business financing, the majority of owners and senior executives overlook the assessment of Opportunity Costs. Why? I believe it’s because they tend to weigh the definable cost of money more heavily than all the other costs associated with business financing.

Let me explain. Opportunity Costs are not restricted to monetary or financial costs. They rightfully also include:

  • Sales not pursued (because cash is not available to cover associated costs – yielding lost profit)
  • Vendor discounts not taken (yielding lost profit)
  • Lost time (time spent pursuing one financing alternative when a different alternative could have been consummated more quickly – this means the executive’s time is squandered which can result in lost profit)
  • Emotional impact on the owner(s), the owners’ family, employees and their families (stress associated with business finance issues has implications on many levels)

These are very real yet non-tangible things and because they are non-tangible the tendency is to either ignore or discount their impact on the company’s financial health. That’s a huge – yet understandable – mistake.

It’s understandable because virtually all financing institutions (both traditional and non-traditional) will focus on the numbers when underwriting a transaction. They must do so because they are assessing risk. Therefore it only makes sense that the borrower would focus on “the numbers” as well. That is to say, the tangible cost of money.

Unfortunately, only focusing on the numbers almost always means overlooking Opportunity Costs – costs that can be substantial. I’ve seen far too many owners delay action for weeks in an attempt to save a quarter of a percent in the cost of money. Frequently the delay resulted in lost revenue and profit that was an order of magnitude larger than the cost of money. To use an old adage, they were penny wise but pound foolish.

It’s not necessarily easy to assess Opportunity Cost in a financing situation. That’s because most banks/financing companies won’t assist in the analysis. After all, they want to close the deal so they’ll be pitching the advantages of their specific course of action – regardless of whether it’s the optimum solution for you at that time.

It’s up to the owner/executive to assess his/her Opportunity Costs. The optimum decision might mean paying a slightly higher cost of money in order to get funds soon enough to take advantage of an opportunity. After all, what good is saving $1,000 on cost of funds if you lose out on $10,000 in additional profit?

There are quite a few options for business financing. They include:

  • bank loans (either direct or SBA guaranteed)
  • personal credit (credit cards; home equity; etc.)
  • borrowing from friends and family
  • selling shares of the company (diluting equity)
  • invoice factoring
  • merchant account financing
  • crowd funding
  • various forms of asset based lending

Some of these can be immediately disregarded based on understanding where you stand in the credit world. For example:

  • If your company is less than 2 years old you won’t get a bank loan
  • If you company provides a consumer product or service you won’t have Accounts Receivable to factor
  • If your personal credit is bad you chances of borrowing are very slim to nonexistent

Once you are able to determine which options are available to you, it’s time to assess both the hard cost the Opportunity Cost associated with each option to determine which one give you the greatest immediate advantage. Once you know that, embrace the option and build your business.

Leave a Reply

Your email address will not be published. Required fields are marked *