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.

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.