Why it's good to keep an eye on opportunity cost as an entrepreneur
Opportunity cost is a term often used in economics. But what does that really mean? And why is it good to keep track of it when running a business?
As an entrepreneur, you are faced daily with various choices and priorities, big and small, and for every choice you make it means that something else stands back. It doesn't have to be that you actively choose one of several options, but your resources are not endless. Therefore, each resource used in a certain way leads to the fact that the same resource cannot be used in a different way. And this is where the opportunity cost comes in. The opportunity cost describes the lost revenue, or value, of the option that was removed.
There is therefore much to be gained from learning about opportunity cost. Because if you take it into account in decision-making, it will allow you to make more informed decisions that benefit your company the most. When you invest time, money, or other resources in one part of your business, you indirectly opt out of other potential investments. Considering what is sacrificed allows you to make more informed decisions that maximize the use of resources and have the greatest impact for the company both in the long and short term.
Using opportunity cost in decision making
Once you've figured out what opportunity cost means, you should take that into consideration when making decisions related to the company. Consider all options before making your decisions and settle into what you will give up in case you choose the respective options. By doing so, you can become better at analyzing the different options, estimating the value of your resources, and prioritizing what brings the highest return.
When it comes to different investments, opportunity cost can come into play in different ways depending on whether it's an either-or decision or whether it's about how to allocate a resource. Let's say, for example, that you are going to buy a machine and choose between two options. Option 1 is cheaper, but option 2 has higher capacity and therefore can produce more. Simplified, then, the opportunity cost if you choose option 1 becomes the loss in production that option 2 had given, which would have subsequently led to you being able to sell more. If you had chosen option 2 instead, it would have meant that you would have had to spend more money initially and thus prioritize something else. The opportunity cost of option 2 would have been what you could have used the difference if you had chosen option 1 instead. Here, then, it becomes a trade-off to see which choice would have yielded the greatest return in terms of the overall picture.
Opportunity cost thinking can also help you prioritize and value your time as an entrepreneur better. A clear example is the question of managing finances yourself or hiring someone. Hiring someone costs money, but doing it yourself means you need to put the time into it. You then need to sacrifice time that you could have spent on things that generate revenue. You can either save time or money and the trade-off becomes whether or not the income you had generated during the time you saved would exceed the cost of taking help. Another example is whether they should prioritize between different ventures and problems. You may have four different things you are able to accomplish in a given period of time. Three of them require less resource use while one requires more, and you need to choose between making the three smaller or the larger one. In this situation, it is easy to grasp the smaller tasks as they are likely to have a shorter starting distance and it feels good to get things done. But if all three smaller efforts together have less effect than the larger one, it is a waste of resources to prioritize them instead of the larger one.
Opportunity cost and financing
Have you ever considered whether to save up for an investment or take one business loans and make the investment here and now? Or have you been thinking about whether to increase your purchases but are afraid of burdening liquidity too much? On both of these occasions, the opportunity cost had helped you make the most optimal decision. If you save up for an investment instead of using financing, you will certainly save on the cost of interest rate. But had you made the investment with the help of finance, you would have received a return for it sooner. If you save up for it, the opportunity cost becomes the lost return in the period until you make the investment. If the opportunity cost is higher than the interest cost of the business loan, your company would have benefited from the use of financing. The issue of financing larger purchases works in a similar way. Is the potential profit you can generate from making larger purchases, i.e. the opportunity cost in case you don't, higher than the cost of financing, making larger purchases using financing is optimal.
The long-term effect
By leveraging opportunity cost, you can make more informed decisions that maximize your company's resources and generate the highest possible ROI. This will allow you to become better at identifying potentially profitable opportunities, navigating change, and not sticking to strategies that are not optimal. All in all, you'll be better at planning for the future, setting realistic goals, and developing strategies that leverage your company's strengths and capitalize on market opportunities. This will make you more successful in your business.
