Opportunity Costs

Business owners and managers face a myriad of choices every day. We make hiring decisions, market and product choices, advertising decisions, and scores of other choices. Most managers are adept at evaluating the cost of the alternatives, but few consider what economists refer to as the “opportunity cost” of these choices.

Opportunity Cost is an economic term that describes the costs (in terms of currency or benefit) that is foregone by selecting one of an exclusive pair of choices OR the costs incurred by hesitating in making a choice in the first place.

The first type of opportunity cost occurs where there are two alternatives to choose from, but only one option can be chosen. The cost of an alternative that must be forgone in order to pursue a certain action is the opportunity cost. Put another way, this is the value of the benefits you could have received by taking an alternative action.

OPPORTUNITY COST TYPE 1: Some people call this the “alternatives cost.”

To illustrate, a wise investor will consider the difference in return between a chosen investment and one that is necessarily passed up. If you invest in a stock that returns 2% over the year as opposed to placing your money in the alternative stock that gives a 6% return, you gave up the opportunity of the second investment – or had an opportunity cost in addition to the actual investment. In this situation, your opportunity costs are 4% (6% - 2%).

The opportunity cost of going to college is the money you would have earned if you worked instead. On the one hand, you lose years of salary while getting your degree; on the other hand, you hope to earn more during your career, thanks to your education, to offset the lost wages.

The second type of opportunity cost occurs when a decision is delayed for some reason. The reason for delay may be a good one – thorough evaluation of alternatives for example. Or the decision may be delayed due to over-analysis, fear, hesitation, or simple laziness. Here the opportunity cost is the sum of values NOT realized had the decision been made timely.

OPPORTUNITY COST TYPE 2: Also known as the “hesitation costs.”

For example when a manager hesitates in hiring the needed candidate, thinking that another better- suited one will appear, the opportunity costs are the loss of productivity that occurs during and after the delay, and this cost can never be recovered. Presumably if there is a real need to hire someone, then there are values associated with that new employee, and each day of hesitation brings a loss of value – an opportunity cost. There may also be costs to morale/productivity within existing workforce due to delay of hiring needed workers, and thus this type of opportunity cost can escalate dramatically.

Farmers know that if they hesitate long enough in the decision as to which crops to plant (corn, wheat, soybeans tec.), it can mean the loss of the entire harvest since full growing season can not be realized. This equals a 100% opportunity cost, and consequently farmers never hesitate with these decisions. Unfortunately hiring managers sometimes don’t evaluate this type of opportunity cost as effectively.

A good friend was recruited for a senior management position in a large multi-national corporation. The interview process was rigorous, but my friend emerged as the top candidate. Unfortunately the hiring decision became mired down with hesitation and distractions on the part of the hiring managers. The process dragged on for nearly 3.5 months in total, and by the time the employment offer was delivered, the process itself demonstrated the poor management of the company and the offer was rejected. The company not only suffered the opportunity costs of delayed productivity, and loss of morale, but in this case had to begin the recruitment and selection process anew as well as suffer with reduced management credibility.

Opportunity Costs, both Type 1 and Type 2 are a reality of business life, but the best managers both evaluate and minimize these critical costs in operating their business.