Opportunity Cost -- The Concept

In my last post I suggested that the idea of “opportunity cost” was critical to a business owner’s decision making. Before getting more deeply into the analysis of that idea I think we’ve got to make sure we’re on the same page with respect to definition.

What is “opportunity cost”?

At its core, opportunity cost is the profit that a company loses (or forgoes) by NOT doing something.

Opportunities come in different varieties.

In one standard example there is a fixed amount of capital available and two competing potential uses. In that case the opportunity cost would be the expected profit from the option NOT chosen. In other words: I choose to take option #1 but, in doing so, I lose the potential profit from option #2.

More often in today’s economy we confront opportunity cost in a different sort of choice i.e. we can either expand our business or not; take advantage of trade discounts or not; pay on time to avoid penalties or pay the penalties.

In these cases the opportunity cost is the cost of NOT taking on that additional client or NOT bidding on that additional contract; or NOT getting the discount; or actually paying the penalty.

You get the idea.

If the availability of money is the controlling factor in that decision, then the cost of that money must be considered in relation to the opportunity available.

Let’s use an example that might be familiar to many. You’ve got a good idea for a business: a good product or service; the experience necessary to deliver it; a provable market; a good plan; but no money to put your plan into effect and no access to traditional financing.

You approach someone who has the money to back you, who might agree to furnish the capital in exchange for a share in the business.

The cost of funds in this case is not the annual percentage rate that your backer might earn. The true cost is what you would lose by NOT moving forward. As they say: “It’s better to have 50% of something than 100% of nothing.” This is not the mindset found in the traditional borrower/lender relationship.

But then let's say your business gets going and the demand for your product is good. Your customers are pleased and want to buy more. You’ve now got another problem.

You have to pay your staff weekly and your suppliers in 30 days but your customers don’t pay you for 60 days.

Your working capital can’t support an increase in your business volume even though the demand for your product is there. You still can’t access traditional financing sources and your partner has put up all the money he’s willing to.

So there’s another opportunity cost problem. If you can get your money in 5 days instead of 60 days, maybe you can double your business volume. The analysis of the cost of capital is NOT the annual percentage rate that you would calculate as if you were buying a car.

The cost that should be driving your decision (assuming, again, that you do not have access to a bank line or a home equity loan) is the difference between the profit that you could earn by expanding your business (or decreasing other costs) and the cost of the capital that will allow you to do that.

As long as the profit from the opportunity available is sufficiently greater than the cost of the funds needed, the opportunity should be considered.

Remember: It’s not appropriate to measure the cost of funds that ARE available against the theoretical cost of funds that are NOT, in fact, available.

Businesses focused on growth have to be oriented to recognizing and siezing opportunity.

And so it is the analysis of opportunity cost that has to drive the big decisions.

The Cost of Factoring # 2

In my last post I continued to explore the differences among the basic types of factoring relationships.

The traditional full-line factoring relationship typically involves more money, minimum required transaction volumes, minimum required commitment periods, a broad array of services and better credit.

Spot factoring, on the other hand, typically involves smaller transactions, no required minimum time periods, no required volume commitment, weaker credit and, essentially, a single service.

The cost in time and effort to establish a traditional factoring relationship can be recaptured over a known minimum period of time and volume of transactions. This leads to a pricing structure that is more closely related to the factor’s cost-of-funds. Frequently these relationships will require a basic cost-of-money element stated in terms of a spread over the prime rate, but they will also typically include a range of service fees.

For example: there might be a fixed additional fee applied to each invoice purchased, a processing fee for collections, an accounting and reporting fee and fees for all money transfers. An annual account maintenance fee might include the costs of analyzing required updates of the client’s financial statements and new credit reports and UCC searches.

While the stated cost-of-funds in such a relationship is an easily understood item, the total cost of the relationship has to be evaluated in light of the charges for the various services provided.

The spot factoring company, on the other hand, because it’s pricing is predicated on a single transaction rather than a longer-term commitment, will most often quote an “all-in” fee based on the face amount of the invoices being purchased.

The cost-of-funds element of the spot factor’s pricing will typically be a smaller component of the total cost than would be the case for the traditional full-line factor. That is because the spot factor has to accept the possibility that it will complete only one transaction with a prospective client. If that is, in fact, the case, the time and effort required to establish the relationship and close that single transaction will be a much larger element of its cost than the cost-of-funds itself.

In fact, the spot factoring company will almost always lose money on a single-transaction relationship.

We are all accustomed to converting costs in a financing relationship to an annual percentage rate. And most of us have certain benchmarks; like the interest rate on a car loan, a home mortgage or a credit card; against which we measure those costs.
In factoring relationships those benchmarks are of minimal value.

In the case of full-line factoring, the benchmarks have minimal value because of the range of services provided in addition to the value of the funding itself.

In the case of spot factoring, the benchmarks have little value because the nature of the relationship and the costs associated with it bear little resemblance to the relationships in our normal benchmarks.

Especially in the case of spot factoring, the cost that is most important to analyze and understand is OPPORTUNITY COST.

That is, answering the questions:

a) What is the value of the opportunity that the factoring arrangement allows me to pursue that I could not otherwise pursue? or

b) What costs can I AVOID by having the money owed to me NOW rather than, say, 45 or 60 days from now?

I’ll address the opportunity cost issue in my next post.

The Cost of Factoring #1

In my last post I wrote about the differences in expected duration among the three basic types of factoring relationships. And I concluded with the point that those differences also caused the pricing of each to vary.

My next few posts will address the issue of pricing.

In any kind of financing relationship there are several elements that affect cost: size, duration, cost of origination and servicing, and risk of default, for example. And, of course, the provider of the financing has its own cost of capital to cover.

I started my career in the commercial mortgage business. One of the first things that I was taught was that it takes as much work to make a $1 million loan as it does to make a $10 million loan. Essentially the origination process is the same regardless of size. So, the smaller the transaction, the higher the relative cost of origination.

In the same way, the shorter the duration of the loan, the greater the impact of origination cost. Recapturing origination cost over one year will obviously require a relatively higher rate than recapturing that cost over ten years.

The same general issues hold true in the factoring business. Even though the duration of factoring relationships isn’t as long as those of mortgage loans, the principle is the same.

The longer duration of the traditional, full-line factoring relationship, allows pricing to be relatively lower because the factor’s costs are recaptured over a longer period.

In the case of a spot-factoring relationship, where it is possible that the relationship will consist of only a single transaction, origination costs will represent a larger component of transaction pricing.

The traditional, full-line factoring relationship will also typically involve a significantly higher volume of funds advanced than will the spot-factoring transaction. And the higher the volume, again, the lower the relative cost of establishing the relationship.

I’ve also noted previously that the companies that enter into full-line factoring relationships tend to be larger firms with longer track records and better credit than those that seek spot-factoring relationships.

Those characteristics obviously command lower pricing commensurate with lower risk.

So, the size, duration and credit risk in the typical full-line factoring relationship are significantly different from those in the spot-factoring relationship and those will all affect pricing.

More on this subject in our next post….

The Interface Financial Group has been helping businesses with their cash flow needs since 1971. Solving cash flow problems is what we do.