What Is An Opportunity Cost?
An opportunity cost is the benefit you give up when deciding to choose one alternative over another. This type of trade-off is inevitable when running a small business with limited time and resources. For example, if you decide to stock up on inventory (or do nothing) instead of putting the money toward fixing equipment, your opportunity cost is the productivity you would have gained with fully-functioning equipment.
The most successful business owners are aware of their opportunity costs and focus on making decisions that lead to the greatest long-term value. Others fail to consider opportunity costs and either do nothing or delay important decisions. Below are some examples we’ve seen of when opportunity costs were considered properly. Hopefully, they can help you make the best decisions for your business.
Example 1 – Buying Inventory or Doing Nothing
A local bicycle shop had the opportunity to purchase 30 premium road bikes for $30,000, which could be sold for $40,000. They didn’t have the money, but a lender stepped up and offered them a loan to cover the purchase for 1 year at a total cost of $5,000 (including all interest and fees).
The owners (we’ll call them Ryan and Melissa) knew they had to make a decision fast, but only one was thinking about the opportunity cost of doing nothing.
What Ryan thought – They shouldn’t take the loan to buy the bikes because the cost of the loan was higher than they wanted to pay (even though it was the best offer they could get).
What Melissa thought – They should buy the bikes using the loan so they don’t miss out on the opportunity to:
- Make $5,000 off the sale of the bikes
- Make an average of $200 on additional accessories for each bike
- Get up to 25 new customers who will likely need maintenance services and more bikes in the future
- Sell the inventory quickly to either put the $40k+ toward even more bikes or pay off the loan early (to save on interest)
Eventually, Melissa was able to convince Ryan that the opportunity cost was too high to do nothing and he agreed to move forward with the loan.
Example 2 – Choosing Between Investing Now or Later
Timing is crucial in making the right decisions for your business. If you don’t make timely decisions you can slow down your business’ growth and allow your competitors to surpass you. Imagine that you discovered that consumers were seeking out a certain product that you didn’t stock. Investing in a new product line may require you to make a big investment in your inventory. You may feel that you should hold off on taking a loan and hope the trend dies down. However, if your competition were to get the new product line before you, this could cause your customers to seek their business instead of yours. Your decision to wait could cost you long-term profitability.
In another case, deciding to not invest in the productivity of your business could slow down growth as well. As equipment gets older it’s inevitable that their productivity will decline. Your inefficient equipment could cause you to waste additional time completing work. This would stop your business from realizing growth. Often, business owners find that improving their operations can help them save thousands a month!
It’s important to take advantage of the right opportunities if they’ll provide you with a positive return or a strategic benefit. If you’re missing out on a chance to grow because you don’t have enough working capital it might be worth seeking a short-term loan so your business can move forward.
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