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Opportunity Cost: The Hidden Drain on Profits

When a business owner looks at a profit and loss statement, it’s pretty clear which items affect the cost of doing business: payroll; rent; utilities; inventory purchase price; etc

What is harder 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 by pursuing a particular course of action instead of a mutually exclusive alternative.” In other words, if you decide to opt for Option B, you will lose any benefits you would have gotten from Options A or C.

As an executive or owner, you want to minimize opportunity costs. It does this by weighing the benefits and drawbacks of EACH of the options before you. This allows you to get a clear picture of each possibility and allows you to select the option that best meets your immediate (and possibly medium-term) needs. Once that decision is made, move on.

For whatever reason, when it comes to business financing, the Opportunity Costs assessment is overlooked by most owners and top executives. Because? I think it’s because they tend to outweigh the definable cost of money over all the other costs associated with business financing.

Let me explain. Opportunity costs are not limited to monetary or financial costs. They rightly also include:

• Unchased sales (because cash is not available to cover associated costs, resulting in lost profit)
• Supplier discounts not applied (producing lost profits)
• Lost time (time spent looking for a financing alternative when a different alternative could have been consumed more quickly; this means that the executive’s time is wasted, which may result in lost profits)
• Emotional impact on owners, family of owners, employees and their families (the stress associated with the company’s financial problems has implications on many levels)

These are very real but not tangible things and because they are not tangible the tendency is to ignore or dismiss their impact on the financial health of the company. That’s a huge but understandable mistake.

It’s understandable because virtually all financial institutions (both traditional and non-traditional) will focus on the numbers when signing a transaction. They has to do it because they are assessing the risk. So it makes sense for the borrower to also focus on “the numbers.” That is, the tangible cost of money.

Unfortunately, focusing solely on the numbers almost always means overlooking opportunity costs, costs that can be substantial. I have seen too many homeowners delay action for weeks in an attempt to save a quarter of a percent on the cost of money. Often, the delay resulted in lost revenue and profit that was an order of magnitude greater than the cost of money. To use an old adage, they were wise with pennies but fools with pounds.

It is not necessarily easy to assess the opportunity cost in a financial situation. This is because most banks/financial companies will not help in the analysis. After all, they want to close the deal to present the benefits of your specific course of action, regardless of whether it’s the optimal solution for you at the time.

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

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

• bank loans (either direct or guaranteed by the SBA)
• personal credit (credit cards, home equity, etc.)
• borrow from friends and family
• sale of company shares (capital dilution)
• invoice factoring
• merchant account financing
• fundraising
• various forms of asset-based lending

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

• If your company is less than 2 years old you will not get a bank loan
• If your business offers a consumer product or service, you will not have Accounts Receivable to factor.
• If your personal credit is bad, your chances of getting into debt are slim to none.

Once you can determine which options are available to you, it’s time to evaluate both the direct cost and the opportunity cost associated with each option to determine which one gives you the greatest immediate advantage. Once you know that, accept the option and build your business.