Opportunity cost: the hidden factor in strategic decision-making

In any modern business, making decisions requires a few trade-offs. This is the reality of many small or medium business owners who face limited cash flow. While they captain the ship towards success, there are hidden reefs or currents to navigate. One of them is opportunity cost.

This financial concept allows firms to make smarter and more informed choices that can further fuel their growth toward success. In this expert guide, we’ll define opportunity cost, reveal some practical examples, explain how to calculate it, and provide important tips to consider when evaluating your options.

What is opportunity cost?

Opportunity cost is the potential benefit a business forgoes when it chooses an alternative over another. It is the value of the next best alternative that is not selected. 

For SMBs, this concept applies to everything from marketing strategies to equipment purchases. It helps firm managers evaluate the merits of various options and the alternatives they don’t opt for. 

To give better meaning to what opportunity cost is, let’s consider this simple analogy. Imagine standing at an ice cream stand. With enough cash to buy a cup, you are asked, “Flavor A or Flavor B?” These are two great options, but you can only choose one. Whichever flavor you select, you miss out on the other. That’s the opportunity cost in a nutshell.

While we can’t predict the cost of every outcome with certainty, it plays a key role in strategic planning and decision-making. Thus, weighing the potential benefits of every financial decision can help you make more informed and profitable choices for your business.

Why opportunity cost matters for SMBs

Many SMBs thrive on limited resources, including time, cash, and labor. Therefore, understanding opportunity cost can help owners decide where to allocate them, which can impact long-term and short-term business profitability. Here’s why it matters.

It helps businesses make informed choices

As you understand potential trade-offs at a given time, you can weigh the benefits of every financing option and choose the one that best aligns with your overall business goals.

It optimizes businesses’ available resources

Although limited, time, money, and manpower are precious for any SMB. Consequently, identifying opportunity cost can help them allocate these resources appropriately and maximize their impact.

It reduces risk

Indeed, every decision has an element of risk. As such, considering opportunity cost allows businesses to anticipate potential downsides and adjust to mitigate them. 

How to calculate opportunity cost

The formula for calculating opportunity cost is straightforward:

Opportunity cost = return on most profitable investment choice (RMPIC) – return on investment chosen to pursue (RICP)

This basic formula helps organizations compare the expected returns of different options to determine the most valuable choice. Let’s apply this formula in the example below.

A company has $10,000 to invest, and there are two options to consider:

• Option A: Invest in a new piece of equipment. This will increase production capacity, which is expected to generate an 8% return over the next year.
• Option B: Invest in a marketing campaign. This option will attract new customers and could generate a 12% return over the same period.

Using the opportunity cost formula:

Opportunity cost = 12% (RMPIC) – 8% (RICP) = 4%

What does this mean? When this company chooses to invest in new equipment, it forgoes a 4% higher return from the marketing campaign. Conversely, if it aligns its model with marketing, it forfeits a lower return from purchasing new equipment.

Ultimately, this simple calculation helps SMBs see the financial impact of choosing one option over the other.

Do you want to scale your eCommerce business? Here's how your eCommerce business can overcome financing barriers in 2024. 

More practical examples of opportunity cost for SMBs

Now that we’ve considered how to calculate opportunity cost, let’s preview a few scenarios that SMBs commonly face. 

1. Hiring new staff vs. upgrading technology

Running a business in the modern age demands newer upgrades. You can choose to acquire new staff to handle the increased workload or enhance your technology for more efficiency. Hiring new staff may generate $60,000 in annual revenues, while investing in improved equipment may yield $80,000 in the same period.

Opportunity cost = $80,000 (RMPIC) – $60,000 (RICP) = $20,000

In this case, choosing to hire new staff over upgrading technology would mean missing out on a potential $20,000 increase in revenue.

2. Expanding product line vs. opening a new store

As more customers flow into your business, there will be an increased demand for products and services. Now, it’s time for an upgrade, and you have $1 million budgeted. The two options available are to either expand your product line or open a new store in a new location.

The first option could offer an additional $450,000 in revenue over the next two years. On the flip side, opening a new store could generate $550,000 over the same period.

Opportunity Cost = $550,000 (RMPIC) – $450,000 (RICP) = $100,000

This would translate to a $100,000 potential loss in sales, as adding new products is a better option than opening a new store.

3. Training current employees vs. hiring experienced professionals

To ensure streamlined services for its customer base, a business may need to either train current employees or hire experienced professionals. Training current employees will increase productivity and could see a 15% increase in revenue. Conversely, hiring experienced professionals could see a 25% revenue increase.

Opportunity Cost = 25% (RMPIC) – 15% (RICP) = 10%

Therefore, opting to train current employees instead of hiring experienced professionals would result in an opportunity cost of 10%.

Expert tips on how to evaluate opportunity cost 

It’s important to note that there’s more to opportunity costs than formulas or calculations. Understanding this can empower you to become more strategic in your business. Let’s consider these expert tips:

1. Identify all available options

Since resources are limited, listing all potential choices that will utilize them effectively is proper. This step ensures you know every avenue that could help you achieve your targets. Be thorough in your research and consider even the less obvious options. Remember, the more choices available, the better positioned you are to make an informed decision.

2. Estimate the returns

Next, you want to know each option’s cash flow forecasting. Accurate forecasting helps you understand the long-term viability of each option. It also ensures you’re not caught off guard by unexpected expenses and helps you understand how each option will impact your financial health.

Want to know more about the importance of forecasting? Here are 7 reasons why businesses should embrace cash flow forecasting.

3. Compare the options

Use the opportunity cost formula to compare the returns of each choice. This tip allows you to make decisions that align with your goals and resource constraints. It helps you prioritize options that benefit you most while minimizing potential risks.

4. Consider non-financial factors and make an informed decision 

While financial projections are great, it’s imperative to consider risks, alignment with business objectives, and long-term impacts before making a business decision.

Considering alternative financing options

Opportunity cost provides key insights into how businesses can properly channel their resources. However, that may not be enough. Thankfully, there are a variety of financing avenues that can help SMBs bridge the gap between opportunity and reality. Here are some options to consider.

E-commerce financing

E-commerce financing is an excellent choice for online businesses seeking investment in website development, marketing campaigns, or inventory purchases. Repayments are usually tied to your online sales.

Debt financing

Debt financing is an option where you can borrow a large amount of cash from a bank or lender. It’s very helpful for one-time investments, like buying equipment. While going for it, your business must keep two essential things in mind: interest rate and repayment conditions.

Revenue-based financing

This innovative financing model provides capital based on your future sales potential. Repayments are based on a certain percentage of your revenue. Thus, your growth directly impacts your repayment schedule. 

Make every decision count

In the finance world, every decision carries an inherent opportunity cost. By understanding and carefully considering these costs, you can make more informed choices that align with your business goals.

Additionally, by partnering with Stenn, you can maximize value, minimize risk, and stay ahead of the competition. We realize the challenges SMBs face during their nascent stages. As such, we offer different financing options that can help you seize key opportunities and achieve profitability. 

Our revenue-based financing gives you the capital to grow and remain in control. It’ll help you strategize better and move your business forward. Don’t let limited cash flow prevent your brand from achieving its full potential. Contact us today to discuss your financing options and make every decision count.