Understanding Opportunity Costs

Do you think you understand opportunity costs?  Let’s see. . ..

Imagine you are eating at an all-you-can-eat buffet.

You can take as much food as you want, but in reality, you can only eat so much food.  The jambalaya looks and smells delicious, but this buffet is known for its meatloaf.  You choose the jambalaya.

What is your opportunity cost of eating the jambalaya?

It is not eating the meatloaf—do you understand opportunity costs now?

Opportunity Costs

As small business owners and entrepreneurs, we know a little about opportunity costs in business.  We understand that to invest in a stock, means we don’t have money to invest in a bond.  The interest difference is the opportunity cost.

If we invest money in research and development, that is money we don’t have to invest in marketing, so the opportunity cost is the marketing opportunities we lost because of not growing our marketing efforts.

Strictly speaking, the opportunity cost is the cost of not being able to do something because you are doing something else.

Good business decisions are made when we spend as much effort on evaluating the costs and returns of the decisions we don’t choose as we do on the decisions we do choose.

Good decisions are made when we know the costs of all the alternatives to the decision being made.

As businesspersons, we are most adept at calculating the opportunity costs of our business decisions in terms of dollars.

Time

Unfortunately, we are not very good at calculating opportunity costs that include time.

For Employees

What is the opportunity cost when we don’t require our employees to take a lunch break or a vacation?

An elemental evaluation indicates the company benefits more from employees working and not taking time off.  But that’s true only until we subtract the value of an employee’s work deteriorating from exhaustion, the loss of employees to competitors, and the loss of future employees because of our reputation of over-working our employees.

Ourselves

The same is true for calculating our personal vacation time.  Sure, if we keep working, we can generate more business.  But the cost of our exhaustion and deteriorating reputation is much greater than that of an employee.

Statically, slightly over half of all small business owners take a vacation, which is further evidence we really don’t understand opportunity costs.

Opportunity Cost with Time

What is more telling about how little we understand opportunity costs is what we do with our regular work time.

For example, we spend 11 minutes perfecting an email to a customer.  We could have done a good job on the email in one minute, but we spent the extra 10 minutes making it 92% perfect (for example).  Was it worth it?

The opportunity cost is what else we could have done in that remaining 10 minutes.

Instead of perfecting the email we could:

  • Read a chapter on a new business book featuring one of your potential new markets
  • Call one new potential client
  • Dig deeper into the budgets of one project
  • Catch up with one key employee

As business leaders, we need to be better at incorporating the value of our time into calculating the opportunity cost of all our actions.

The Bible

Everyone should read and study the economic lesson found in Matthew 25:14-30.  In this story, a man, as he was leaving on a trip, gave each of three servants a bag of money to care for.  Two invested the money, and the third buried it in the ground.

When the man returned, he asked for an accounting.  Two servants did well; the third simply had a dirty bag of the original money.

While this story has many lessons, the lesson here was the opportunity cost lost by the third servant was at least the interest earned on the bag of money.

The bags of money represent a metaphor of the time we are given by God to do what He has asked of us.  Each bag is a limited amount of time.

While we can get over eating the jambalaya instead of the meatloaf, we cannot recover any of the time we lose while doing one activity of little value rather than spending our time and efforts on the things of greater value.

Value your time highly, and consider the opportunity costs of all your actions.  Your time is more precious than gold, spend it wisely.