Opportunity cost is the biggest cost a PM is responsible for
Do you what is opportunity cost?
If not, then buckle up. Because this is the most important cost that you are responsible for as a product manager.
In this article
- What is Opportunity Cost
- Understanding Opportunity Costs as a PM
- How to determine Opportunity Costs
What is Opportunity Cost?
Let’s start with cost. We all know what is cost.
in our personal lives, we incur many costs. Housing, clothes, food, books, internet, cell phones, cars are all costs that we pay for so that we can live and enjoy our lives.
Similarly, if you work in a company, they also incur costs to stay operational. Salaries, office space, laptops, snacks are all costs.
In a previous article, I had explained three types of costs – Direct, Indirect and Economic costs. You can read the article here.
Direct and Indirect costs are also called cash costs. Why? Because you are paying for the goods or services in cash. But economic costs are not cash costs, but they are costs nonetheless.
Let’s imagine, you want to buy something expensive. Say a Rolex watch, or a BMW, or a Hermes Birkin purse. Let’s say the cost of this item is $ 50,000. (I just googled – a Hermes Birkin purse was selling for half a million dollars.)
This is the cash cost. But what if you could invest that money somewhere. Say an ETF that grows at 10%. You could have earned an appreciation of $5000 in the first year itself. Then it would compound as long you hold.
So your cash cost is $ 50,000 but your opportunity cost is $ 5000. No one pays for the opportunity cost. It’s not cash. But it is cash, you “could have” earned. That keyword is could have. The potential interest that was foregone.
Sometimes its called tradeoff cost. We face trade offs all the time. If your friends decide to go for an outing or a movie, but you have to study, the opportunity cost for you is the lost time with your friends and enjoying a movie. If you do go out, then you risk not doing well in your exam and perhaps repeat a term. Thats your opportunity cost of going out.
Let’s take an example in a business scenario. The company has budgeted $ 1 Mn for marketing. The marketing spend will result in more revenue in future.
What is the opportunity cost? Well, with $ 1 Mn, you could have finally replaced that machine that keeps breaking and improve product and quality of your product, which in turn will reduce customer returns. The cost of customer returns and the maintenance of the machine is the opportunity cost for spending on marketing.
The job of a manager is to understand the trade offs and then analyze which is the right option taking into all costs including opportunity costs. If you have ever been in a dilemma about two equivalent choices, you are basically figuring out the opportunity costs of the choices.
In Economics, this is an important concept when making choices. From an economic stand point, you pick a choice that has a lower overall costs direct + indirect + opportunity costs.
Opportunity costs is the benefit you forgo from the next best alternative. The cost of the Rolex is not $ 50K, but $ 55K.
In the business example, the $ 1Mn spent on marketing will result in poor product quality and $ 200K in customer returns. The cost of the marketing program is really $ 1.2 Mn.
What if we spent that money on the machines. We will reduce customer returns and avoid the $ 200K return cost. But we will forgo a revenue uplift that we could have got from the new marketing spend. So the cost of the machine is $ 1 Mn plus the revenue loss.
If the revenue loss is more than the cost of the customer returns, than you would likely choose marketing spend.
In a perfect world with infinite resources, you want it all. But in the real world, you cannot. So you trade off.
The technical definition of opportunity cost is :
Opportunity costs = return on next best alternative (foregone option) – return on chosen option
Note, the management may decide to go for a decision that shows a higher opportunity cost. There could be many reasons for this. Perhaps you are in a competitive situation, and if you don’t spend on marketing, you will lose significant revenue. Or perhaps you decide to invest in something today to be placed strongly in the market in future. Those are management decisions. But the job of the managers is to present all the costs, including opportunity costs, so that the right decision can be made.
Understanding Opportunity Costs as a PM
All this economics mumbo jumbo is great, but what has this got to do with me. I am just a PM delivering capabilities that provide value to my customer.
Thats true. Your job is to provide value to your customer. But how you do know if you are providing the BEST value.
Let’s see where product managers encounter opportunity costs.
1. Opportunity cost due to product choices:
Let’s say you have chosen to add a new feature that will help the customers with their analytics and help reduce churn by 3 percentage points. It will need 3 developers and a UX person full time for a quarter. You presented a clear plan of action. That’s great.
But your management will want to know what you are trading off. Could the developers be better utilized in adding those much needed APIs, or fix those pesky bugs that will reduce support calls. Your product choices need to be traded off against the next best alternative. Of course, you will need to know what the alternatives are and then determine, which is the next best alternative.
Understanding tradeoffs is a constant feature of a PM role. You will be required to justify that creating that analytics capability is the BEST option for the company and the customer.
Trade offs can be across feature sets across your backlog. It can also be across product choices. If you are a product leader that manages a portfolio of products, you will need to bake off where your resources are best invested in. Should you work on the mobile app experience or add the new analytics capability. Should you replace the front end library now or wait?
These are tough choices but it starts with understanding your alternatives and the relative cost of those trade offs.
A tip : When you do present your recommendation for your product or feature to management, mention the trade offs. That way you can set expectations on what you are forgoing in terms of benefits.
2. Opportunity cost on lack of customer and market understanding :
Your end goal as a PM is to have such a good understanding that you are solving the most important problems for your market and customers.
But what if you do not have a good understanding. Many PMs, will do lazy discovery, and try to solve problems that are plainly visible. Or worse, you are just take orders from your sales teams or executives and ship what has been requested.
You may be showing progress to your management, but you are likely not solving problems that are more impactful, or those that can help with growth of your product. Your role is to ensure you have done your research on your customers so well, that all challenges are visible and you can select the most impactful one.
Lets take an example. You think that adding a product feature will help a specific persona. But you got blindsided that another group of personas could benefit with just a minor tweak. That’s the opportunity cost of not doing enough research.
Sometimes we create features without a full understanding of our user persona. Say you create this new reporting tool for sales people, but you fail to account that sales people are not that technical savvy. So they end up not using the feature and adoption drops. In comes a competitor who has a solution better suited for sales people. Your lack of research resulted in the opportunity cost of losing customers.
3. Opportunity cost from solution choices:
Even if you select the most important problems that provide revenue growth for you, your solution choices can have a cost.
Recently, I was using a customer service CRM and wanted to create a report. But the design was poor and took me so much time, and they were lacking some basic UI components. After a while, I stopped using. Imagine a set of users for whom the reporting is important. They will likely find a competitor with better reporting.
And if the user ends up calling support, that’s an added cost. The cost of poor design is loss of customer.
Another example where opportunity costs is incurred is onboarding. If the onboarding is not designed well, customers could churn. So investing in an onboarding tool or process is important to reduce churn. Not having onboarding in place has an opportunity cost of churn.
4. Opportunity cost of technology choices:
When you build a product, you a have a lot of technical choices. When I was at SugarCRM, I was the PM for the reporting tool. After scoping the reporting feature, we found it might take us a year or more to build the most important features that were causing churn amongst customers. I looked at options to buy the solution from a partner and integrate. That would be quick and we can generate revenue sooner.
The partner of course would have a direct cost we will need to pay for. But the opportunity cost was managing another team in a new country, loss of control on roadmap etc. The cost of building in house was lost revenue during the time we are building. If the revenue loss was really large, then perhaps we could have gone with a partner. Unfortunately, the partner had the functionality but they were on an older tech stack. Which created another set of opportunity costs. The opportunity cost was just too large. So we decided to build it in house.
When you build an app, there are many choices you have to make – choice of frameworks, choice of libraries, vendors to integrate. Each of the choices will have trade offs. You will need to work with your engineers to determine the opportunity cost for the solutions you short list.
Say you choose a specific javascript library. It allows a fast development time, but has scale issues. Which might result in customer support complaints. That is an opportunity cost.
Other examples:
- Choosing a proprietary technology for a product may provide unique features but could result in vendor lock-in and limited compatibility with third-party integrations.
- Opting for cutting-edge but relatively unproven technologies may offer potential innovation advantages but could also introduce higher development risks and longer learning curves.
5. Cost of decision delays or inaction :
As a PM, you need time to do proper discovery and validation. Then you need to work with engineers and stakeholders and create alignment. All of this takes time.
What if you take longer than anticipated to reach a decision. Prolonged debates and indecision regarding product roadmap priorities delay feature releases, allowing competitors to capture market share and potentially leading to decreased customer satisfaction.
Inefficient development processes and bottlenecks in decision-making lead to missed deadlines and delayed product launches, resulting in reduced revenue and prolonged time-to-market compared to competitors.
Some PMs want to strive for perfection before starting development. That costs time and time results in opportunity cost.
Not creating alignment results in increased discussion time and more meetings. All of those will contribute to delays and potentially revenue loss or increased cost.
There are many such examples that result in delays and indecisions that contribute to opportunity costs.
Determining opportunity cost
In order to make better decisions that factor in all costs, you have to first understand the alternatives. Out of those alternatives, pick the next best alternative. Let’s say there are three features, and you can only do one. You will need to trade off each.
You select Feature A, then assess what are you missing by foregoing Feature B and C. Same if you select Feature B or C.
if you select Feature A, then reduce the business impact by the cost of the next best alternative. Do for each combination.
Fortunately, most business decisions boil down to two choices so it is easier to determine the opportunity costs. But in some cases you will have to play the permutations. The most important point is to understand the alternatives and factor the lost returns.
To summarize:
- Identify Options:
- Clearly define the different alternatives or choices available.
- Estimate Benefits and Costs:
- Evaluate the potential benefits and costs associated with each alternative, including both quantitative and qualitative factors. Include cost of onboarding, support for your chosen option.
- Compare Trade-offs:
- Compare the benefits and costs of each alternative to understand the trade-offs involved.
- Quantify Opportunity Cost:
- Calculate the opportunity cost of choosing one alternative over another by determining the value of the benefits foregone from not selecting the next best option.
Conclusion
You encounter opportunity costs at all times as a PM. You are probably just not aware of it.
Opportunity cost is an important factor in deciding between trade offs and how you spend your precious resources. Resources are not just the hard cash you will spend, but also your own time and your engineers time.
Always think – Am I provide the BEST value to my customers? Am I working on something that will generate the HIGHEST possible business impact?
Sometimes you will not have all the answers. And thats OK. But your goal is to assess each opportunity against each other. And that will help you become a great PM.
