We all know about the fixed and variable costs of doing business, but have you ever heard the term, “opportunity cost?”
While the term may not be a true accounting term, it is still a very important concept for business owners to understand.
I like to define opportunity cost this way. If your company has an opportunity to make a sell to a credit worthy customer that will generate a net profit margin greater than the cost of financing the project or sell, then the opportunity should be considered. If the opportunity can’t generate enough profit to pay fixed, variable, and financing costs than perhaps it shouldn’t be considered.
I often tell clients to measure the cost of financing opportunities in dollars rather than in interest rates. Since you pay your employees in dollars rather than annual percentage rates, you shouldn’t measure opportunity costs in annual percentage rates. You should estimate the total dollars that it will take to finance a project or large increase in business. Then calculate how much net profit the sale will generate. Compare the two and you have your answer.
Hopefully soon our economy will start rebounding and inexpensive lines of credit are going to be difficult to find. Many companies have depleted their working capital and don’t have much, if any safety cash to operate. This will make growing sales difficult. It will require businesses to seek other ways to obtain working capital.
For those businesses that have had lines of credits with banks for the past several years, there have been many companies that have reached their maximum borrowing limit and don’t have enough profits to pay the line of credit back. They pay interest month after month and still don’t have enough working capital.
Companies that have had a non-performing line of credit at an APR of 6.25% may have paid many more dollars in finance costs than a company that has been using accounts receivable lending at an APR of 18% when the A/R line is self-liquidating. This is of course making the assumption that the amount of credit extended is the same, albiet for different periods of time.
Business owners will have to become more creative in seeking financing for their businesses as their sales increase. Working capital financing with a factoring company or A/R lender is an example.
If you find that your company is starting to strain its working capital, think about opportunity costs. Either you can turn down a sale or project because you don’t have enough working capital or you can compute the opportunity costs. If they opportunity costs are less than the profit you will earn on the business, the alternative financing will be worthwhile.
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EXTRA: If you have questions for Sam regarding business financing, the credit market, and similar issues, please send an e-mail. Your questions will be recorded and Sam will answer the best ones in his Ask the Expert podcast show.