Operation managers have to weigh the pros and cons of each decision and how it could affect the business. Opportunity cost is a key factor in the decision-making process, as it aims to leverage existing resources in the most efficient way possible by establishing their value in various applications. So, letโs find out how the principle of opportunity cost works and see what are the best ways to utilise it!
What is opportunity cost?
Opportunity cost, in the most simple terms, can be defined as the cost of missed opportunities. When you are faced with multiple choices, taking one option over another will inevitably cause you to miss out on the benefits the alternative would have offered. However, your selected option would bring you other advantages and for the decision making to be successful, these should be better than the potential advantages of the alternative.
To be able to make the right decision, you need to understand what this potential benefit you might be missing out on is, or in other words – you need to calculate and evaluate the opportunity cost. This is done by comparing the costs and benefits of each alternative to identify the more profitable solution.
How is opportunity cost calculated?
Opportunity cost can be calculated using a simple formula that looks at the expected ROI for your chosen option and its alternative:
Opportunity Cost= FO โ CO
Where:
FO = Return on investment of the disregarded alternative
CO = Return on investment of the chosen option
However, the practical implementation of this calculation isnโt always as straightforward as it initially seems. When choosing whether to invest in expanding your product range you have to consider the explicit cost (i.e. how much you would pay to get supply, hire more sales staff, etc) and think how else you would have been able to use that capital (e.g. could you have improved the office space, invested in stocking more items of already existing products and marketing those better).
In addition to that, there is the implicit cost – or a cost that doesnโt necessarily have to have an upfront financial value. If you donโt invest in the new product and keep the money, it doesnโt cost you anything at the time. In the future, however, you forgo the opportunity to capitalise on the profit you could have made had you been the first business to sell this new product thatโs not available on the market yet.
Opportunity cost examples in the context of fulfilment & supply chain management
Calculating opportunity cost can help you make better decisions when it comes to managing inventory, choosing the right fulfilment strategy or even doing stocktaking correctly. Here are three examples of how this economic concept can be applied in real-life business situations:
Capital tied up in stock thatโs sitting on shelves could have been spent on making transactions to expand the business and could have ensured a better cash flow. On the other hand, opting for a just-in-time (JIT) approach (keeping as little stock as possible and reordering only when close to running out) could lead to the inability to fulfil orders due to factors out of your control, such as delays by suppliers and manufacturers
Choosing a merchant fulfilment model to manage fulfilment allows you to keep costs to a minimum as you are not paying an external party to do the job. However, by not choosing a third-party logistics (3PL) provider you may have lost out on an opportunity to free up time for business development, scale up your business and make more money in the long run by increasing the speed and number of fulfilled sales
When choosing whether to invest in inventory management software or third-party inventory management services, you have to calculate whether the cost of the payment you commit to upfront is lower or higher than the cost of the labour, time, training and human error you would have to pay if you did everything in house
5 tips on using opportunity cost in fulfilment and supply chain management
If you are in charge of the decision making process for fulfilment, logistics and supply chain management in any organisation, understanding how to best use the concept of opportunity cost will definitely come in handy. Here are 5 tips to help you make successful decisions using opportunity cost:
Donโt forget time, resources and people all have a cost
Not all costs can be seen upfront. Paying a 3PL provider has a cost that you will be quoted upfront and that can be off-putting. Deciding to do everything yourself will also have cost, even if it isn’t as clearly- defined. Think how you could have used the time your staff will be paid for that could have been used elsewhere to develop the business
View people as a factor relevant to opportunity cost
What may seem like a financially sound decision may lead to dissatisfaction, reduced productivity and subsequent losses if it doesnโt align with the general feeling expressed within the business. For example, trying to maximise the profit by altering the drop-off and pick-up practices within the business may fail if it doesnโt take into account the circumstances of the drivers – where do they live compared to the new locations, what routes are they familiar with, etc.
Never make decisions in silos
If your sales team works on commission, they will want to give more discounts to get their sales numbers up but at the same time, you have to keep an eye on the profit margins. Promising next-day delivery may be something that your marketing team identifies as a great promotional headline but you have to think of the logistics cost. Making budget cuts by restructuring can be practical at the time but the cost of hiring, recruiting and training new staff when a tough deadline approaches may be a lot higher. This is why you can never make opportunity cost decisions in silos – you should always consider the impact on the business as a whole and in the long run.
Consider how the value of money changes over time
It comes as no surprise that opportunity cost is all about making the right financial decisions, hence money and profit are the primary focus. However, you always need to balance current capital with the potential future value of money to be able to correctly estimate the possible benefits of all your options.
You always miss out on something and thatโs OK
The key to using the opportunity cost concept effectively is accepting that there will always be a loss, whichever choice you make. There are no perfect solutions. You should not feel discouraged thinking about the benefits you are losing out on. Instead, you should feel excited by the advantages you will get by making the right choice.
As abstract of a concept as opportunity cost may appear to be, it is, in fact, quite relevant to the business decisions you make every day. Hopefully, using the opportunity cost examples and tips above will help you confidently make better and smarter choices in the future.
