OPPORTUNITY COST
“If a window of opportunity appears, don’t pull down the shade”
– Tom Peters, Strategy Guru
Strategy comes down to opportunity cost…creating better opportunities than the ones you have, and constantly ensuring scarce resources (people, time, and money) are focused on those opportunities that will generate the most value. I always tell leaders, “you have only so much time, money, and resources, so you better make it all count and major in the majors.”
It took a while in my career to truly appreciate the importance of opportunity cost in strategy and decision-making. The concept can be challenging to wrap your brain around, but once you do it will improve your decision-making and your ability to think through strategic options.
A strategy is the prioritized actions necessary to unleash the value potential of an organization. Given an organization’s scarce resources in the form of people, time, and capital, it is critical to ensure the collective actions an organization pursues over time are optimal, given the vast potential of options available. The essence of strategy is navigating through options and picking the ones that are optimal for creating significant value and minimizing opportunity costs.
What is opportunity cost?
The most substantial cost in a company is not payroll or the cost of goods sold and doesn’t show up in financial statements. The most substantial cost in a company is opportunity cost, which is the value lost, in revenue or cost savings, of pursuing one course of action versus another.
I’ll give you a simple example to bring opportunity cost to life.
I worked with a retailer that had a loyalty program with 20 million members. The loyalty team was four people, and they were struggling to formulate and execute the capabilities and loyalty campaigns to drive loyalty within those 20 million. The CEO met with a company looking for us to invest in a database of 2 million potential customers. The CEO asked me, “what do you think about this opportunity?”
To which I replied, “for me, it comes down to opportunity cost. I would rather have the loyalty team focused on driving value out of 20 million actual customers than trying to figure out how to mine new customers out of 2 million non-customers. Furthermore, I think you may want to enlarge your loyalty team and reallocate some of the 100 people who work on creating a newspaper ad that goes to 12 million households every week. We’ll probably get more value out of those reallocated people focused on 20 million loyalty members than newspaper ads that go to just 12 million households.”
Take a look at the opportunity cost illustration below.
To understand the importance of opportunity cost, one has to simply reflect on some of the poor choices once-prominent brands made in creating their demise. While Kodak invented the first digital camera, they decided not to embrace digital photography, fearful it would cannibalize their film sales. Motorola, the once-dominant leader in mobile phones, neglected to timely leverage their best-selling RAZR into a smartphone, which, coupled with competition from Google and Apple, led to a decline from $43 billion in revenue in 2006 to $22 billion in just four years later in 2010.
You can evaluate opportunity cost in discrete situations, such as the return on investment of one HR system versus another HR system. Though, opportunity cost becomes more important when you are evaluating investments across the business model. An organization has a scarce amount of resources in the form of people, time, and budgets, and how strategic leaders allocate the investment of these resources largely determines the value the organization will create.
Allocating budget, people, and time to one initiative or function negate the investment of those resources in other initiatives and functions. And, if those other initiatives and functions offer a better potential return on the investment of budget, people, and time, then the organization will incur an opportunity cost. Allocating the scarce resources of time, people and budget is one of the most difficult, yet important activities of strategic leaders, for those decisions, are the first steps to a path of success or failure.
How do I minimize opportunity costs?
The best practices for minimizing opportunity costs are:
Have a strategy
Companies that don’t have a clear strategic vision have a difficult time with opportunity costs. A clear strategy naturally aligns activities to realize the goals of the strategy. The performance of companies is pretty binary. Those with a clear and strong strategy grow, and those that don’t have a strategy, typically shrink.
Focus resources on what is important
The purpose of an organization is to develop and deliver the customer value proposition and go-to-market to fulfill the needs of target customers better than competitors, all for the purpose of achieving the mission and vision of the company. Is your organization focused on this? Typically the answer is an emphatic “no.” If you want your company to grow and kill the competition, you need to focus the organization’s energy on creating competitive differentiation, while also driving better customer value than the competition. This short-hand strategy will minimize opportunity costs.
Know the relative value of options across the organization
Great CEOs are good at understanding where they need to invest their resources given all of the opportunities across their business and business model. They understand where they can drive the most value, whether it is opening up new customer segments, or new markets, tweaking parts of the customer value proposition, driving efficiencies in the organization, creating a new pricing strategy, amplifying the proposition through better marketing, increasing strategic distribution, changing the incentive model, etc., etc. There are millions of things a company could do, but great CEOs can figure out the few big things the company should do to maximize value.
Create better options
Opportunity cost can delve into the realm of the unknown and can be that sinking feeling deep down in your gut after you missed a big return on investment. The first step in minimizing opportunity cost is creating better options and knowing those options inside and out.
Know the objective value of your options
It can be difficult to understand the value of your options, but you must do everything you can to try to, for the quality of your decision-making comes down to how well you can objectively compare two seemingly disparate options. Also, you need to try to eliminate biases, which can be extremely difficult when discussing the budget and headcount allocation across an organization.
Filter decisions through scarcity
To get a gut feeling about opportunity cost, one of the best questions to ask yourself or a group is, “If we had an extra $10,000 or $100,000, where would we invest it to drive value?” Or, the flip side, “If we were down to a few months of cash left in the business, where would we invest our time?” Typically the answer helps identify where the big opportunities are, though, sometimes, with these questions you can get some funny answers, like “I would get my resume ready.”
Understand synergies
Look for opportunities to leverage existing investments, teams, products, etc. Find opportunities where 1+1 is greater than 2.
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