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Monday, July 26, 2010

Opportunity Returns

I want to get back to the subject of opportunity cost because it’s critical in the process of decision making in the context of limited resources.

The fundamental concept underlying this subject is that the important analysis of cost is RELATIVE, not absolute.

The cost of funds to a business cannot be properly analyzed except in the context of the available alternatives and potential opportunities.

Let’s take those one at a time.

If a business owner has access to:

a) a bank line of credit,
b) a home-equity loan,
c) a cash infusion from a potential partner,
d) a loan from a relative, or
e) funds from the sale of receivables,

the analysis of alternatives can be very complex.

Which has the lowest cost? Which has the longest term? Which requires giving up equity? Which gets family involved in business? And so forth.

The decision process will depend on the issues of highest priority to the owner. And the choice might, or might not be, the low-cost alternative.

If a business owner has multiple opportunities, for instance:

a) bidding on a significant amount new work,
b) hiring additional staff.
c) buying more efficient equipment,
d) increasing marketing efforts, or
e) buying out a competitor,

the analysis can also be very complex, but will depend on two principal factors, the expected profitability of the opportunity and the cost of funds necessary to pursue it.

So the problem is one of finding the right balance between the potential opportunity and the cost of pursuing that opportunity.

Now, let’s simplify things so we can get to the point more easily.

Let’s say that there is only one potential source of funds and the cost of that funding is x%.

In that case, all of the potential opportunities would be measured against the cost of funds from that source.

And the question becomes: “Does the available opportunity generate a sufficiently higher return, after payment of funding costs, to make it attractive?”

So let’s take an extreme example, just for illustration.

Let’s say you have the opportunity to sell your product at a price that will generate a 100% profit. But you don’t have the money to make the product. The only source of financing available will cost 33% of the potential profit.

You can either: a) refuse the order and make no profit, or b) accept the order, pay the required cost of funds, and make a 66% profit instead of 100%.

Notice that the cost of funds here is cited ONLY in relative terms. It could be the equivalent of 15% per year or 50% per year. In this analysis it doesn’t matter.

What matters is that there are no other better alternatives that would allow you to earn the profit from the available business.

The cost of money RELATIVE to the profit opportunity is the name of the game.

Do you take the opportunity or not?

The opportunity cost in this example would be the 66% lost profit. Every business owner will have some threshold at which the cost of the lost opportunity outweighs the cost of the funds needed to move forward.

And every business owner should have a clear idea of what that threshold IS -- for that business at that time.

Good decision making is INFORMED decision making. And a solid understanding of the opportunity cost concept is critical to informed decision making -- especially in an era of limited resources.

Monday, July 19, 2010

What Matters Most to Business Owners

I’m going to interrupt my series of posts on the subject of opportunity cost to share some information about the motivations of private business owners that I found very interesting.

The data comes from the Pepperdine University Private Capital Markets Project, which conducts extensive regular interviews among both the providers of capital to privately-owned business and the businesses that seek private capital (as opposed, that is, to raising capital in the public bond and stock markets).

In the Winter 2010 edition of the Pepperdine report is a fascinating section entitled “What is most important to you as a business owner?”.

The three goals to which the participants were asked to respond were:

1. Maintaining current lifestyle.

2. Dramatically increasing lifestyle.

3. Financial independence (defined as increasing the value of their business by at least 3 times)

The possible answers were:

a. Most Important

b. Next most important.

c. Least important.

Here’s what I found most interesting.

The least important goal of these business owners, by far, was “Dramatically Increasing Lifestyle” with only 9.9% choosing that as their most important objective.

By far the MOST important goal, chosen by 67.3%, was “Financial Independence”.

Note the definition of “financial independence” is a function of building value in their businesses; specifically, increasing value by at least 3 times.

“Maintaining current lifestyle” was actually seen as more important than dramatically increasing lifestyle.

So these owners of private business are pretty much content with their CURRENT income. What’s really important to them is building value in their business to provide for their FUTURE independence.

This idea of weighing current benefits against future benefits is a fundamental issue in applying opportunity cost analysis, which is why I bring this topic up now.

In my next post I’ll get back to opportunity cost and bring this issue of motivation into that discussion.