Why Opportunity Cost Analysis Creates Better Business Decisions

Today's business leaders need every edge they can get. Competition - paired with economic uncertainty - is just that tough.

In this challenging landscape, one of the best ways to optimize your business decision-making is to incorporate economic ideas that help you better analyze the choices your company faces. One of the best of these ideas is "opportunity cost," which provides a framework for the efficient allocation of resources.

To help you get a better idea of how it works, let's start with some background information about the opportunity cost formula.

What is Opportunity Cost?

When you're faced with a decision, you generally have multiple options available. Let's say you have a limited budget and have to choose how to allocate it. You make your best decision, then may wonder about how things would have turned out had you chosen to fund something else. Opportunity cost is the value of that next best option you don't choose when making a decision.  

The formula for calculating opportunity cost is not complex and should not be intimidating. In its simplest terms, it is the return of the next best alternative minus the return of whatever choice you make.

Let's say a company chooses to invest $500K in manufacturing equipment. In this case, the opportunity cost could be the profits it could have made by taking that same money and investing it in business acquisition/sales. Or, if the project you choose generates $1 million in profit while the next best alternative that you didn't choose would have generated $1.2 million, the opportunity cost is $200K. Fairly straightforward, right?

You can use this opportunity cost formula to analyze return on investment/internal rate of return and other financial metrics. It can also be used to analyze production capacity, productivity, time saved or spent and customer satisfaction.

How to Deploy Opportunity Cost Analysis

Knowing when to consider opportunity cost is important. Some of the most typical resource allocation scenarios include making spend management decisions about capital investment; choosing which products to develop; prioritizing time management; making hiring and staff allocation choices and selecting which technologies to adopt.

If your organization is facing tight budgets and must make tough choices, using opportunity cost as a prism by which to evaluate those choices can be highly effective. It enables you to quantify the sacrifices associated with each option and get a more holistic picture of the true cost of each decision. And when every dollar counts, taking this holistic approach becomes even more critical.

Making Better Business Decisions

By getting a good grasp of opportunity cost, an organization can optimally deploy their limited resources. While opportunity cost isn't a tangible line item on a financial statement, it's just as important for sustainable business success as any other metric.

Let's take a moment to walk through implementing opportunity cost analysis step by step. First, you should list all possible choices you have for resource allocation. These should be all the viable and relevant options. Next, collect as much data as you can about costs, benefits and risks. Once that is finished, it's time to estimate the expected return of each choice. The next step is ranking the options based on expected return, calculating the opportunity costs and making an informed decision as to how to allocate.

As you move forward it's important to measure your results against your estimations of returns. This can help you refine your approach and derive more accurate analyses of the costs and returns of each approach. Ultimately, you'll be able to make the most informed decisions possible and create maximum value throughout your business.

Additional Benefits of Opportunity Cost

If you aren't quite convinced yet, let's run down the advantages of the opportunity cost approach.

• You have access to deeper and more detailed evaluations, enabling more complete and considered decision-making.
• You can allocate limited resources to the areas with highest impact.
• You gain strategic clarity into the projects that truly move the needle.
• Negotiations with vendors, customers etc. are now backed by actionable data, perhaps improving your position.
• You can identify risks and liabilities that may not be immediately obvious.

An Opportunity Cost Scenario

To help reinforce those advantages, let's consider a quick real-world scenario. Let's say your company needs a new travel and management solution. Your choices are staying with the manual approach you’ve always used, or adopting an automated, integrated solution such as SAP Concur.

First, you start by collecting data, such as: 

• How much you spend on labor and manual expense processing
• Employee time spent creating expense reports
• The cost of errors 
• The value of time spent on manual work that could be spent on revenue generating actions 
• Compliance rate and the costs of non-compliance

Then, you calculate the cost of implementing the automated solution. This could include subscription fees, upfront implementation costs, the value of time saved when booking travel and creating expense reports, the value of increased compliance and fewer errors, reduced maintenance costs, etc.

Finally, you calculate the costs of both and make your best decision. Given the substantial inefficiencies involved with manual processes, the increased errors and the risks of lower compliance, the opportunity cost of not modernizing your approach to travel and expense may be considerable. This doesn't account for less easily tracked benefits, such as employee morale and satisfaction, which can be positively impacted by removing some of the most frustrating aspects of corporate travel and expense management via automation.

Ultimately, choosing automation can help employees spend much less time on administrative work, boost compliance, increase data visibility, optimize cash flow, shorten reimbursement cycles, and significantly lower errors. And the real cost of a manual approach extends far beyond basic labor expenses; it greatly limits the value a company could create if it uses automation to replace tedious, low-value, manual tasks.

Here are some stats to remember, taken from a recent SAP Concur survey of 1,800 business decision-makers. Organizations that integrate a travel and expense platform report immediate value creation, including a 26% increase in policy compliance, a 21% increase in cost savings and expense report processing that is twice as efficient.

The Takeaway

If you need a powerful framework for analyzing your most important business decisions, opportunity cost is a smart choice. It can help you go far beyond basic cost comparisons and develop a systematic method for analyzing what you are giving up with each specific choice, ultimately offering better resource allocation and return on investment.