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What Is Opportunity Cost And Why Is It The Only Real Measure Of Success?

The thing about opportunity cost is that it is the one thing most business people never stop to consider. The problem with that is if you don’t think about it, or cultivate a deep understanding of it, your business will never reach its potential. The downside to an understanding is that it can bind us to inaction, and inaction in business is death. Today I’m going to discuss what opportunity cost is, how you should manage it and how you can avoid being driven into a stasis of inaction by your understanding of it.

Opportunity Cost

What Is Opportunity Cost?

Every choice you make has a cost. If someone asks me if I want tea or coffee, the opportunity cost of having the coffee is not having the tea. In business we have to use our resources in order to set and achieve goals. The opportunity cost is the things we could have used the resources to achieve instead. This is a vital business concept and yet many business people give it no consideration. When I have encountered those that think about it, it’s only in the most surface level of thinking. For me it’s not just about the use of resources today or tomorrow or this week or month. It’s about the direction of growth for your entire business.

The benefit for us in spending our time thinking about opportunity cost is in being able to maximise our investment. Our time and our money should be spent to gain the maximum return. So when we decide how we spend our investment it’s not just a matter of whether we can make a profit, it’s a matter of how we make the most profit. More than that it’s a matter of how we make the most profit over the longest time period.

The strategic choice you make for the future of your business is very important and cannot be left… Click To Tweet

How Do We Manage Opportunity Cost?

Opportunity CostMostly we think of decisions as an operation where we input data and make a choice of action based on our understanding of that data. But you can do it differently. Think of a decision  like a seesaw (a teeter-totter for my American friends). The data is the pivot point that supports the decision. The outcomes are the different ends of the seesaw. Our seesaw is different from most. It has many spans rather than just one. There are many different possible decisions and outcomes. If we examine all of the possible outcomes we will see which is the best.

This leads us to the danger point. What if there is no obvious best decision amongst all of those possibilities? If there are so many options that you can’t reasonably spend time examining them all, what do you do? Then there are the hidden, unintended outcomes from the decision? It’s possible to reach this point and find you are overwhelmed by the options and possibilities. We have to force a decision because we know that doing nothing is always the worst possible decision. Now we are in danger of choosing badly and squandering our opportunity.

How Do We Avoid Indecision?

We avoid indecision by setting ourselves parameters for our decision. You must deliberately limit your choice. To make a strategic decision on the aim of your business you set a limit to the possible outcomes. This is also a danger point because you can make a bad strategic decision. You can choose short term profit or long term growth. You can choose short term growth for resale or we can choose steady progression. To make your choice you need to know what you want from your business. I can’t tell you that. What I can tell you is what I think.

Opportunity CostThe strategic choice you make for the future of your business is very important and cannot be left to chance. You must consciously choose a direction. Think about Amazon. If you’re old enough to remember the turn of the century dotcom bubble, you’ll know that the rise of the web based business caused a huge flux in the stock market. Everyone knew web based business was the future and speculators moved in rapidly. Dotcom share prices surged unbelievably. Inevitably the market crashed and many businesses were wiped out.

I remember talking about this with an economist friend of mine just before the crash. He knew what was happening and saw the crash coming. One of the companies we discussed was Amazon. One of the few things he got wrong in that discussion was that he thought Amazon would be one of the companies that would go under. Why? Because Amazon had never made a profit.

Amazon

As we now know Amazon didn’t fail and became a vast business that dominates online retail. I think this is because Jeff Bezos made some extremely good strategic choices when he founded his company. For years and years he deliberately eschewed making a profit. Why would he do this when we all know that profit is the motivation for all business? What is the point if we don’t make a profit? The choice taken was to maximise growth over the long term.

Amazon is the book shop that became a general store, then a department store and now a TV channel and movie studio and a vast cloud computing provider. It’s huge and the strategy to grow rather than make profit turns out to have been a stroke of genius. Amazon is still growing at an incredible rate and is now profitable. In the first quarter of 2017 it had revenue of $35.7 billion (details here). Amazon was always maligned for not making a profit. That’s because businesses are expected to prioritise profit. Why? Because most business people and most business analysts do not understand opportunity cost. Amazon does.