Opportunity cost

I can’t refer to any particular survey or study to verify my hunch, but I’m sure by far that Economics is one of the most popular and in-demand classes on a college campus (yawn).

I know I took several economic classes because these classes are listed on my college transcript. Except for a faint memory of shifting supply and demand curves, the only concept that I remember with some clarity is the concept of opportunity cost.

Wikipedia defines opportunity cost as “the cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).” When I attended college, the first time I read this definition I responded, “Huh?” After reading the definition again for the second and third time, I had the same response.

Now, after 28 years in my own business, I understand the concept of opportunity cost. If you were never introduced to this concept or if you need a refresher course, let me offer an illustration that I believe will help you understand opportunity cost.

The purpose of a business is to obtain a customer. Most business owners and every sales person alive have the mindset that any customer is a good customer as long as there is a penny or more of profit in the transaction. I see this mindset most in brand-new companies where the owners are full of excitement with a bit of fear and are willing to take on anybody as a customer. So you might ask yourself, “What’s wrong with this? Selling a product or service for a profit is the function, the purpose of any business.”

The goal for most business owners and managers is to maximize the company’s profit. It is natural then to think that any customer won for the business is a victory. However, what is often overlooked is the customer’s opportunity cost. The time and resources committed to a marginally profitable customer can prevent you from acquiring or serving a highly profitable customer (the value of the next best alternative foregone). It might be better for you to refer this customer to your competition.

How do you know when to fire a customer? This decision is as much art as science. The first action is to try to make your marginally profitable customer a highly profitable customer. This may simply mean you need to talk with your customer to improve matters. But some customers are just high maintenance, unhappy, and will never see the real value you have to offer.

In our culture of personal customer service we tend to define our success as making our customers happy. However, every transaction should be a win-win transaction. If you are not on the win side of the equation with your customer, then renegotiate your position. If the customer doesn’t value your product or service he will go down the street. You might have to emotionally reset, but you need to recognize that this is a good thing. You now have the opportunity to pick up another customer, a more profitable customer.

The concept of opportunity cost can also be applied to your employees. The wrong employee in the wrong job may have an opportunity cost that prevents your company from operating efficiently and more profitably.

You may view yourself as a nice person and you can’t bring yourself to fire a slightly productive employee because they have children at home or because you just like them. It’s good to consider the human cost when you get to fire someone. But your primary promise is to your customer. If this person prevents you from keeping your promise to your customer of high-quality products and service, you just need to suck it up and deal with it.

The concept of an opportunity cost is not considered enough in trying to maximize a company’s net profit and cash flow. If you never thought in terms of opportunity cost, give it a try. I bet it will mean more money in your pocket.