Risk and working capital often drive decisions in the supply chain, putting operations managers in a position to weigh one option against another.
About Opportunity Cost-Opportunity cost isn’t generally taught at business school, but the concept is used every day in a variety of business functions, including operations management. It’s the idea of trading one thing for another, and hoping to get more benefit from the chosen action, Funda Sahin PhD, associate professor of supply chain management at University of Houston, told Supply Chain Dive.
One example is considering how to introduce a product to the market. Managers must decide whether to introduce it en masse, or test the product in specific locations to see the consumer reaction. If the product is a hit but there’s not enough inventory in stock, the product could die. “Customers are not always willing to wait if they have alternate sources to get similar products,” Sahin said.
She recommends making opportunity cost decisions with a long-term perspective. The company may want to forgo the short-term benefits of marketing existing products, by investing in the new product production, marketing and distribution, in hopes the investment will pay out over the long term.
1. Working capital drives decisions
Often opportunity cost comes down to money – how it’s allocated, how much to borrow and when the funds will be returned. “As the cost of keeping working capital is increasing, more and more financial institutions are looking for more conservative ways to borrow money,” Weiwei Chen PhD, associate professor of supply chain management at Rutgers Business School, told Supply Chain Dive.
Companies must be careful about funding decisions. Dell has successfully kept a negative cash conversion cycle, where customers pay for products before Dell has to pay vendors, said Chen. That’s not the case for all companies. Those taking 60 to 90 days to sell products or receive funds from customers can hold up production or make production more expensive if working capital isn’t available. “If money sits in accounts receivable, they can’t generate another batch of production and the chain of funding is cut off,” he said.
“In every business decision, involve all relevant parties.”
Associate Professor of Supply Chain Management, University of Houston
As part of his research, Chen is developing models to determine the best way for companies to manage their capital, inventory, accounts receivable and accounts payable. He’s also investigating the agency theory in finance, where a manager’s bonus may be tied to the company’s net profit.
Investors’ concern with return on investment (ROI) might clash with the manager’s financial objectives. “Our model can explain what position will favor the supply chain manager versus the stakeholders. We try to explain the optimal capital allocation they want to make by themselves, as well as credit borrowed from funding resources,” he said. The key message, though, is to monitor working capital, so the company runs efficiently.
2. Risk management, opportunity cost go hand in hand
Measuring risk is not just about profits, but weighing the potential benefits of using resources one way in the event worst-case scenarios and supply chain disruptions happen. As part of that, companies may look at supply chain redundancy, spending extra to obtain additional supplies or duplicate production capabilities, to reduce potential disruptions caused if part of the supply chain is broken.