Business Decisions: Consider Opportunity Costs when Allocating Capital
Every business operates with a limited amount of capital. A company can issue only so much equity (stock) by attracting investors. If a company borrows funds to operate, it eventually reaches a point at which lenders stop financing new loans.
Because the amount of capital is limited, managers need to make decisions that maximize the profit earned with their available capital. A decision to invest in product A may mean that product B isn’t funded. In other words, an opportunity cost is related to every business decision. The business passes up the opportunity to earn a profit from opportunity B, so it can generate earnings from opportunity A.
Whenever you face a business decision that involves allocating capital, consider the potential return on investment in the light of the opportunity cost. Which option is likely to give your business the most bang for its buck?
Increasing market share in the pizza business
Imagine that you own a pizza shop in downtown Springfield. You’ve been toying with the idea of opening another store in the new mall on the west side of town when you get wind that Springfield University, on the east side of town, is planning to build a new dorm three miles from your existing store. Students happen to be your best customers. You can’t afford the time or money to pursue both opportunities (the mall location and the store near the new dorm), so you have a decision to make.
You calculate the costs of both options and discover that the total costs are nearly equal — approximately $100,000 for furniture, fixtures, and build-out, along with $22,000 per month for building rental. Payments on the $100,000 loan at 7% for ten years are $1,161.08 per month, so you’re looking at total monthly costs of about $23,160. Unfortunately, you don’t have sufficient cash flow to pursue both options, so you have to pick one.
The choice is a toss-up, right? Well, not exactly. Examining the opportunity costs for both options may lead to a clear choice. You hire a market research firm to help, and here’s what the firm finds out:
If you open a larger store near the dorm and expand your menu, you stand to increase food sales and rent out space to the college for conferences and other school events. Expansion would increase your revenue by 50% or $35,000 per year.
If you open a new shop at the mall, you’re likely to see a 100% increase in pizza sales annually, for an increase in total revenue of about $71,500.
Now the choice is clear. You decide to build your new store at the mall. After all, your opportunity cost (the revenue given up) is only $35,000 per year. If you were to expand near campus, your opportunity cost would be more than double that — $71,500 per year.
Fiat and Chrysler: Expanding to meet competition in a growing market
In 2013, Fiat made a decision to purchase Chrysler. Fiat already owned a portion of Chrysler; the merger allowed Fiat to combine the two firms. The combined company issued more common stock to the public to finance the purchase.
So, why the need to raise more money? The new Fiat/Chrysler entity intended to expand in the fastest growing car market in the world: China. The company planned to use the stock sale proceeds to develop new vehicles and to update auto plants in China.
This expansion allowed the newly combined Fiat/Chrysler entity to maintain and hopefully expand its share of the Chinese car market. Ford, a major competitor, was also spending billions in China. To compete, Fiat/Chrysler had to spend, too.
Of course, Fiat/Chrysler paid some steep opportunity costs when management decided to spend on increasing market share in the Chinese market. It had less money to spend on research and development, constructing more efficient manufacturing plants in the United States, and expanding in Europe. Assuming that management made a wise financial decision, it had to consider these and other opportunity costs.
Keep in mind that every financial decision carries a cost — an opportunity cost. Business owners and managers must always ask themselves whether the capital they’re planning to invest would be better spent pursuing other opportunities.