Opportunity cost isn’t generally taught at business school, but the concept is used every day in a variety of business functions, including operations management. It’s the idea of trading one thing for another, and hoping to get more benefit from the chosen action, Funda Sahin PhD, associate professor of supply chain management at University of Houston, told Supply Chain Dive.
One example is considering how to introduce a product to the market. Managers must decide whether to introduce it en masse, or test the product in specific locations to see the consumer reaction. If the product is a hit but there’s not enough inventory in stock, the product could die. “Customers are not always willing to wait if they have alternate sources to get similar products,” Sahin said.
She recommends making opportunity cost decisions with a long-term perspective. The company may want to forgo the short-term benefits of marketing existing products, by investing in the new product production, marketing and distribution, in hopes the investment will pay out over the long term.
1. Working capital drives decisions
Often opportunity cost comes down to money – how it’s allocated, how much to borrow and when the funds will be returned. “As the cost of keeping working capital is increasing, more and more financial institutions are looking for more conservative ways to borrow money,” Weiwei Chen PhD, associate professor of supply chain management at Rutgers Business School, told Supply Chain Dive.
Companies must be careful about funding decisions. Dell has successfully kept a negative cash conversion cycle, where customers pay for products before Dell has to pay vendors, said Chen. That’s not the case for all companies. Those taking 60 to 90 days to sell products or receive funds from customers can hold up production or make production more expensive if working capital isn’t available. “If money sits in accounts receivable, they can’t generate another batch of production and the chain of funding is cut off,” he said.
"In every business decision, involve all relevant parties."
Associate Professor of Supply Chain Management, University of Houston
As part of his research, Chen is developing models to determine the best way for companies to manage their capital, inventory, accounts receivable and accounts payable. He’s also investigating the agency theory in finance, where a manager’s bonus may be tied to the company’s net profit.
Investors’ concern with return on investment (ROI) might clash with the manager’s financial objectives. “Our model can explain what position will favor the supply chain manager versus the stakeholders. We try to explain the optimal capital allocation they want to make by themselves, as well as credit borrowed from funding resources,” he said. The key message, though, is to monitor working capital, so the company runs efficiently.
2. Risk management, opportunity cost go hand in hand
Measuring risk is not just about profits, but weighing the potential benefits of using resources one way in the event worst-case scenarios and supply chain disruptions happen. As part of that, companies may look at supply chain redundancy, spending extra to obtain additional supplies or duplicate production capabilities, to reduce potential disruptions caused if part of the supply chain is broken.
Tariffs represent another way to view opportunity cost. Moving production away from China could result in higher labor costs but lower tariffs. Stockpiling inventory ahead of potential tariff increases results in higher storage fees and less working capital, but could preserve needed supplies and buffer against higher import tariff fees assessed later. That has to be balanced against prices charged to consumers to maintain margins, while potentially losing sales.
Insurance policies are another risk management aspect of opportunity cost. Funds spent on insurance could be used elsewhere. But if something bad happens, the outcome could be devastating. “Having an insurance policy is more of a long-term approach in uncertain settings,” Sahin said.
3. Analytics can’t be applied in a vacuum
Information flow is one of the fundamental processes in supply chain management, and that’s where supply chain analytics comes in. Employees may use data to analyze ways to optimize operations. Chen cautions against assuming supply chain analytics is the same thing as data analytics. It’s not productive to just use information technology specialists to help with the supply chain management flow, who may lack domain knowledge in production, procurement, logistics and other areas. “Our understanding of analytics has to become combined with supply chain itself,” he said.
When IT and analytics staff apply data to solutions without that domain knowledge, it’s disruptive to the supply chain staff’s workflow. “That’s one reason that analytics solutions haven’t been well accepted by some of the supply chain people,” Chen said.
He gave an example of a trucking company trying to minimize empty mileage with drop-offs and pick-ups. The data analytics engineers gave solutions that weren’t well received by the drivers, and the engineers didn’t understand why. “We find out that there are some very realistic constraints the model didn’t take into account,” Chen said, like the drivers’ domicile locations, favorite routes and personal connections at various locations, which made it a better driver experience. “Without working in the field, you wouldn’t think about it.”
The solution is for companies to train their own analytics staff on operations details. It’s also possible to provide analytics training for the operations staff, but Chen said this is typically more difficult to do. Some universities now offer supply chain analytics masters programs to combine domain and technical knowledge.
4. Measuring opportunity cost: Is there a right answer?
There is no specific KPI for opportunity cost, but there are ways to measure it. Assets need to earn a return. There’s a cost to carrying that asset, and a need to determine the cost against other options.
Sahin noted the antitrust challenges federal lawmakers are currently bringing against tech companies can impact their opportunity costs. Microsoft was tied up with antitrust issues for more than a decade, which kept it from innovating and allowed other technology companies to grow, said Sahin.
"Our understanding of analytics has to become combined with supply chain itself."
Associate Professor of Supply Chain Management, Rutgers Business School
To measure opportunity cost in this scenario, “Look at competitors,” she said. “Other technology companies popped up and took off. Microsoft had to catch up instead of leading.” She recommends considering what the company gives up in competitive advantages over the long term.
With her students, Sahin focuses on the tradeoff concept. A company considering moving operations overseas would be drawn to lower labor costs. But consequences could include quality problems, fixing or replacing products, restoring customer confidence and higher transportation costs. While there is not always a right answer, decisions must be considered from many perspectives. “Am I saving enough by going over there? Will it offset the cost in a different area?” she said.
5. Opportunity cost is a holistic decision
Each sector or function will look at opportunity cost a different way.
The salesperson wants the inventory options to be as large as possible and to have all products available immediately, in order to sell more. So does the fulfillment person, who prefers supply available for fast shipping. Carry too many products, and warehouse costs and accounts receivables rise.
The production manager wants more redundancy in machines and labor. If there’s a deadline, it may be hard to recruit more workers, and demand won’t be met. Finance staff wants to reduce costs, hiring only the people needed and scheduling them carefully, to meet demand.
Each silo should work together to share its own perspectives and determine the best actions for the whole company.
“In every business decision, involve all relevant parties,” Sahin said.
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