Written by Marijn Overvest | Reviewed by Sjoed Goedhart | Fact Checked by Ruud Emonds | Our editorial policy

Opportunity Cost — Maximizing Procurement Efficiency

Opportunity cost is such a hidden game-changer. In procurement, it embodies the untapped benefits that slip through our fingers when we choose one path over another. These elusive costs often go unnoticed due to their intangible nature, but they play a crucial role in refining our decision-making processes.

In this article, we’ll explore how opportunity cost impacts procurement and discover the best practices for minimizing it in your business strategies.

What is Opportunity Cost?

Opportunity costs are the hidden advantages we miss out on when we choose one thing over another. These advantages are often hard to see because they’re not something tangible. But it’s really important to think about what we could have gained if we had made a different choice, whether it’s in our investments or our everyday decisions.

When we understand what we’re giving up by going with a specific option, it helps us make smarter decisions. This knowledge makes us look ahead and think carefully about our choices, so we can grab the opportunities that work best for our goals.

How Can Opportunity Cost Impact Procurement?

Opportunity cost can have a significant impact on procurement processes. Firstly, it affects decision-making. When organizations evaluate different procurement options, they must consider the potential gains they could have from alternative investments.

If they opt for one procurement choice, they are essentially forgoing the benefits that could have been obtained from the other options, and this is the opportunity cost.

Additionally, opportunity cost influences supplier selection. Businesses must weigh the benefits of working with one supplier against the gains they could achieve by partnering with another. This calculation involves not only the immediate costs and benefits but also the long-term implications, as the selected supplier could potentially offer a more advantageous partnership in the future.

Furthermore, opportunity cost encourages efficiency in procurement. Organizations must make choices that maximize their value and minimize losses, which prompts them to prioritize cost-effectiveness and strategic alignment.

Opportunity Cost Formula

The concept of opportunity cost is fundamental in economics and decision-making. It represents the potential benefits or gains that are sacrificed when one choice is made over another. The opportunity cost formula is a simple and useful tool for quantifying this trade-off.

The formula for opportunity cost is expressed as follows:

Opportunity Cost = Return on Best-Forgone Option (FO) – Return on Chosen Option (CO)

In this formula:

FO stands for the “Return on the Best-Forgone Option.” This refers to the benefits or returns that could have been achieved by selecting the next best alternative option instead of the one chosen.

CO represents the “Return on Chosen Option,” signifying the actual benefits or returns obtained from the option that was ultimately selected.

Example of Opportunity Cost Calculation

Let’s consider an example of opportunity cost in procurement using the formula.

Imagine a company is in the process of selecting a supplier for a critical component used in their manufacturing process. They have two potential suppliers:

Supplier A:

• Cost per unit: $100
• Reliable delivery, but no volume discounts offered

Supplier B:

• Cost per unit: $110
• Offers a 10% volume discount if the company purchases more than 1,000 units

The company requires 1,000 units of this component. They can either choose Supplier A or Supplier B. Let’s calculate the opportunity cost of choosing Supplier A over Supplier B.

1. Return on Chosen Option (CO)

If the company chooses Supplier A, they will pay $100 per unit for 1,000 units.

Return on Chosen Option (CO) = $100 per unit x 1,000 units = $100,000

2. Return on Best-Forgone Option (FO)

If the company had chosen Supplier B and taken advantage of the volume discount, they would have paid a higher price per unit but received a discount:

Cost per unit from Supplier B with a 10% discount = $110 – (10% of $110) = $99 per unit.

Return on Best-Forgone Option (FO) = $99 per unit x 1,000 units = $99,000

3. Opportunity Cost

Now, we can calculate the opportunity cost:

Opportunity Cost = Return on Best-Forgone Option (FO) – Return on Chosen Option (CO)

Opportunity Cost = $99,000 – $100,000

Opportunity Cost = -$1,000

In this case, the opportunity cost of choosing Supplier A over Supplier B is -$1,000. This negative value represents the potential savings that the company missed out on by not selecting the more cost-effective option (Supplier B with the volume discount). It’s important to note that opportunity cost can be negative when you forgo potential benefits by choosing a less favorable option.

Indication of Opportunity Cost

Opportunity cost analysis plays a pivotal role in shaping a business’s capital structure. When a firm decides to utilize debt or equity capital, it’s not just about the explicit costs involved, which include compensating lenders and shareholders for the inherent risks. There’s also an opportunity cost to consider.

For instance, funds allocated to repay loans are funds that can’t be invested in potentially lucrative stocks or bonds, which offer opportunities for investment returns. The company faces the critical decision of whether leveraging through debt for expansion will yield greater profits compared to returns from investments.

In this evaluation, the company aims to balance the costs and benefits of issuing debt and stock, encompassing both financial and non-financial factors. Calculating opportunity cost becomes a complex endeavor because it’s a forward-looking consideration, and the actual rate of return (RoR) for these options remains uncertain today.

In procurement, opportunity cost manifests as the unfulfilled potential gains and benefits that could have been realized by choosing an alternative option over the one selected.

It becomes evident when procurement decisions result in sacrifices, whether it be in terms of cost savings, improved supplier relationships, or better terms, as the chosen option may not fully exploit all available advantages, illustrating the trade-offs involved in the decision-making process.

Recognizing opportunity cost is integral to optimizing procurement strategies and ensuring that choices align with a company’s overall objectives and financial goals.

Opportunity Cost and Profits

Opportunity cost can be viewed as the measure of profit gained or foregone as a consequence of a business decision. In this context, there are two distinct categories of profit: accounting and economics.

1. Accounting Profit

Accounting profit represents a company’s net income, often referred to as the “bottom line” since it appears as the final figure on the income statement. The calculation of accounting profit involves subtracting a business’s total explicit costs from its overall revenue.

This figure serves as a crucial indicator of a company’s financial performance. Not only is it invaluable for business owners, but it also holds significance for potential investors and lenders when they assess the attractiveness of collaborating with the business.

2. Economic Profit

In contrast, economic profit encompasses a broader scope. It equals the total revenue minus both explicit and implicit costs. Economic profit can substantially differ from accounting profit, primarily because it takes into account the notion of opportunity costs, which quantifies the value of alternative actions that were not pursued.

Economic profit offers a more holistic assessment of how efficiently a business operates and allocates its resources. It provides insights into whether the business is not only profitable but also whether it makes the most optimal choices in terms of resource allocation. Economic profit, although theoretical in nature, is a vital tool for understanding the deeper implications of business decisions.

Best Practices for Minimizing Opportunity Costs

To minimize opportunity costs in procurement, it’s crucial to adopt a series of best practices that align with strategic decision-making and resource allocation.

1. Create a clear and robust strategy

Companies lacking a strategic framework often struggle with opportunity costs because they lack the necessary guidance to make informed choices. A well-defined strategy naturally aligns activities with overarching objectives, reducing the likelihood of resource misallocation.

This strategic clarity is often the differentiating factor between companies that thrive and those that contract in a competitive landscape.

2. Direct resources toward what truly matters

The primary purpose of an organization is to deliver a compelling customer value proposition and outperform competitors in serving target customers, all in pursuit of the company’s mission and vision.

Focusing organizational efforts on creating competitive differentiation and enhancing customer value is a shorthand strategy to mitigate opportunity costs. It ensures that resources are channeled towards activities that yield the most significant returns and drive sustainable growth.

3. Understand the relative value of options across the organization

Exceptional CEOs excel in identifying where to invest resources amidst a multitude of opportunities, whether it entails tapping into new customer segments, expanding into new markets, optimizing the customer value proposition, enhancing operational efficiencies, or implementing innovative pricing strategies.

They can decipher the few substantial actions that maximize value amid numerous possibilities.

4. Create better options 

By developing superior alternatives and comprehending them thoroughly, organizations can reduce the risk of missing out on valuable returns and opportunities, ultimately improving decision-making.

Moreover, it’s crucial to assess the objective value of available options while striving to eliminate biases, particularly in discussions related to budget and resource allocation. Sound decision-making hinges on the ability to objectively compare seemingly distinct options.

5. Filter decisions through the lens of scarcity 

Doing so can provide valuable insights into opportunity costs. By asking where additional investments would be made if resources were more plentiful or if the organization faced imminent financial constraints, organizations can identify significant opportunities that align with their strategic objectives.

6. Recognize synergies

Recognizing synergies and seeking opportunities to leverage existing investments, teams, and products can be an effective means of optimizing resource allocation. This approach often leads to situations where the combined impact is greater than the sum of individual efforts (1+1 > 2).

In essence, by implementing these best practices, organizations can minimize opportunity costs in procurement and enhance their overall strategic decision-making process.

Conclusion

Opportunity cost is a subtle yet influential factor that significantly impacts procurement strategies. It’s the unexplored potential benefits we forfeit when we make choices. These costs often evade our notice because they’re not something you can touch or see, but they’re vital in refining our decision-making processes.

This article delved into how opportunity cost affects procurement decisions and provided a glimpse of the best practices for minimizing its impact on your business strategies.