To Spend or Not to Spend: The Importance of Opportunity Cost Among Small Businesses
As long as there are finite resources in business, opportunity-cost analysis will be important for business leaders. The way entrepreneur Sam Madden explained it was: "Opportunity cost is essentially what you give up (the benefits of the next best alternative) when you make a choice."
A common example of opportunity cost for small business owners occurs when they ask themselves: Should I strategically save money to have it available for future use, or should I spend it with the hope of investing in future opportunities that can reap dividends?
The first choice -- saving funds -- may limit your growth potential because you fail to fully utilize all your available resources. The latter, on the other hand -- investing -- employs your capital with the expectation that your company can scale faster. By choosing to save your profits, you lose out (your "cost") on the upsides available in investing further into your business (your "opportunity").
Considering these decisions in a vacuum may sound daunting, but thankfully, many experts agree that understanding the role of opportunity cost can make you a more effective decision-maker, both in terms of your personal finances and the long-term direction of your small business.
Cost savings have no inherent value.
To begin with, it's crucial to note that the act of not spending money contains no value judgment on its own. This means that saving isn't a good thing unto itself, while saving on costs isn't an inherently bad thing either. Then there's the fact that "cost savings" sounds especially good when compared with its counterpart on the other end of the spending spectrum: "wasting money."
Still, the overall scenario presents a false dichotomy: Not all money that is spent is a wasted resource, and there are numerous times where a growing small business can get significantly more value out of putting its cash toward a strategic investment than by letting excess funds just sit unused on the balance sheet. For these types of companies, maximizing opportunities and creating processes for thoughtfully responding to them are among the top priorities a business can employ to spur sustainable growth.
With available resources, entrepreneurs can invest in marketing efforts that have a demonstrated, proven ROI. In a 2016 survey of U.S. marketers, the Direct Marketing Association (DMA) and Demand Metric discovered that email offered a median ROI of 122 percent, whereas social media offered a 28 percent ROI; direct mail, 27 percent; paid search, 25 percent; and online display, 18 percent.
Given these statistics, it's clear that money saved when it otherwise would have been spent on digital marketing leads to opportunity cost. Furthermore, when entrepreneurs are faced with decisions about how to allocate their marketing budget, there is opportunity cost in investing in social media, direct mail, paid search and online display advertising campaigns, when email marketing drives significantly higher ROI.
Understand that the future is uncertain.
Entrepreneurs may sometimes feel inclined to save their operating profits, in case sales suddenly slow down and their business begins to lose money. Make no mistake: Planning for the future is vital to a small business's success early in its life. Developing accurate growth forecasts, creating strategies for reaching your goals and scaling your operations to handle future growth are essential for building a stable organization that can adapt to changing realities.
That being said, the only reality you can be absolutely certain of is the one you currently exist in. No matter how good you become at forecasting, there is always an element of uncertainty associated with future events, and that's where the concept of opportunity cost becomes important for small business leaders.
The key when making a significant decision is to not wait for an uncertain event in the future that may never materialize. Use the data available to you at the time to analyze your choices, and pull the trigger if conditions are more favorable than not. Otherwise, you may miss the opportunity completely and be left to wonder, "What if?"
Embrace bold decision-making, but also emphasize adaptability.
Some entrepreneurs think they can please everyone if they don't rock the boat too much. However, the more you come to understand opportunity costs, the clearer it becomes that inaction is often cancerous for a growing business.
Your decisions are rarely going to be universally popular. Depending upon the choices you make, your CFO may feel you're building a culture that promotes wasteful spending; and your marketing department may groan about a lack of resources, while operations people may claim that too much is being asked of them.
This is all a natural part of being a leader.
As long as your decisions are based on data, and made thoughtfully, however, they are ultimately defensible. Jack Welch shared some wisdom along these lines in his book, Winning, that should quell your fears about making bold choices: "Leaders have the courage to make unpopular decisions," Welch wrote. "Obviously, tough calls spawn complaints and resistance. Your job is to listen and explain yourself clearly but move forward. Do not dwell or cajole."
Don't let past mistakes prohibit future actions.
As you learn to be comfortable with making big choices that could shape the future of your company, you also have to become accustomed to making the wrong decisions every once in awhile. Once again, you have to go with the best evidence that is available at the time, which means occasionally, you are going to end up on the wrong side of your opportunity-cost analysis.
This is normal, but what you can't do is let these mistakes corrode your ability to make future decisions. After a failed initiative, some small business owners think keeping the status quo and avoiding any new spending is the antidote. This is the attitude that results in valuable assets languishing on the side lines or being sub-optimally utilized.
Learn to think strategically by recognizing opportunity costs everywhere.
One way to become more comfortable with the realities opportunity costs present is to understand they are a part of everyday life.
Every time you make a choice, whether large or small, you're weighing sets of values against one other. Do you get more value out of eating a slice of pizza (immediate pleasure) or a quinoa salad (long-term health benefits)? Do you stay up overnight to invest more hours into a project (to increase short-term productivity) or do you spend that time engaged in quality sleep (to optimize your long-term output)?
When you take opportunity cost into consideration, you can make calculated decisions about how to allocate your resources and capture more value. Investor and growth expert Brandon Turner believes that time itself should be subject to an opportunity-cost analysis. The way he says this is to insist: "Everyone can earn $1,000 an hour."
Turner argues that plenty of entrepreneurs will encounter "special moments when you make a huge sale, land a big client, install a new product or reach 50,000 people on a podcast" that can generate a disproportionate amount of value for their business. However, too many business leaders spend their time engaged in low-value and menial tasks.
To break that habit, Turner explains his own approach to optimizing time and producing more of those high-value situations: "Take a minute right now and write down what tasks in your business are worth $1,000 per hour," he advises. What tasks are worth $100 per hour? What tasks are worth $10 per hour?" Then, he suggests, "Start outsourcing the $10-per-hour jobs today, followed by the $100-per-hour jobs. Watch how fast your business explodes."
Every time you are faced with an opportunity and a variety of options for moving forward, consider the implications of each choice, including inaction. Conduct a thorough analysis of the potential outcomes of each decision or lack thereof. This should allow you to clearly identify which is the best path forward to build a successful and sustainable company.