How to Calculate Opportunity Cost of Innovation
When corporations start investing in innovation, they try to base decisions on evidence, and only give away enough resources when the evidence justifies the investment. If a team has only done a few customer discovery interviews, the innovation board will only give the team a bit of money and perhaps a bit more time.
If the team has an MVP in the market and is getting good acquisition rates, they might be ready for more substantial investment. If the team has a fully fledged business model showing a clear return on investment (ROI), then they’ll get enough money for a full launch.
But the corporate investors sitting on that innovation board are almost always investing more than they think they are. This can potentially lead to bad decisions and misallocated resources.
When they think they are investing $1,000, they are often investing $10,000.
When they think they are investing $100,000, they are sometimes investing $500,000.
Why? Because they are only considering direct costs, not realizing they are also investing opportunity costs.
What Are Opportunity Costs?
In the simplest terms, opportunity cost is what we could have gained if we did something differently. It’s the loss of a potential gain.
Let’s take an example outside of the corporate context. If I have an idea for a startup, I also probably have no real idea how much that startup is going to make. It might make absolutely no money, but it might make billions of dollars.
I certainly hope it will be closer to a billion than zero, but I don’t know my revenue at this point. However, I do know my costs very clearly.
Imagine that right now, I am totally unemployed, just sitting on my butt, living in my parent’s basement rent-free. Essentially my costs are zero.
I’m not going to pay myself anything, I have no rent, I have no salary.
Costs might appear to be zero. But there’s still opportunity cost.
It’s the cost of the opportunity that I am not taking by working on this startup.
Even in my worst-case scenario, I still have opportunities. I could play guitar on the street corner for a few bucks, or I could get a job over at McDonald’s for $10.21 an hour.
My guitar playing is pretty mediocre, so let’s say that my best guaranteed opportunity is McDonald’s. I’m pretty sure I could nail that interview. So for easy math, I’m going to round down and imagine I can get $10 an hour working at McDonald’s for 40 hours a week.
That’s $400 a week, or about $1600 per month. So that is my opportunity cost.
I am losing the $1600 that I did not earn by working on this startup each month. That’s the cost of missing out on the opportunity to stand by a deep fryer 40 hours a week.
Calculating Opportunity Costs
For corporate innovation, the opportunity cost is what our team members could be doing with their time if they weren’t assigned to an innovation project. The total cost is the direct cost of their salary plus whatever they could have been earning for the company.
So if we’re going to assign a team of engineers to a project, we need to think about what else they could be doing for our core business. Could they be building new features? Optimizing the acquisition funnel? Optimizing SEO? Or just optimizing our algorithms to decrease server costs?
How can we calculate this?
There are actually some great tools for this in the finance department. Concepts like the Cost of Capital and Net Present Value (NPV) take opportunity costs into account for cash costs. The formulas explicitly calculate what your money could be doing instead of being invested in a project. For example, you could invest that money in bonds or the stock market and generate an average Return on Investment (ROI).
We should be aware of those calculations and how the finance team deals with them. So a conversation with our finance team is worth having. But we’re going to look at this in the simplest possible way: Revenue per Employee.
This is an extremely crude way of looking at opportunity costs. But if we take our total revenue for our company and divide it by the number of employees, we get our Revenue Per Employee.
If our company is a retail outlet with revenues of $100,000 per month, and we have 10 employees, then each employee is essentially earning your company $10,000 per month.
If we pull one employee off of the company’s core business to work on an innovation project, that’s going to have an impact. We’re going to lose some sales because customers won’t be getting the level of support they typically have. We might run out of stock because we’re a little overwhelmed in the back office. We might just all be a little grumpy having to do more work, and that might lead to a corrosive environment that customers simply don’t like.
Bottom line, if we assign a team member to an innovation project, we might lose $10,000 per month in revenue.
Again, this is a very crude way of calculating opportunity costs, and is probably not accurate. Perhaps we’ll all just work a little harder, perhaps customers don’t care, perhaps we reassign someone who was a terrible salesperson anyway. Realistically, some people produce more value than others. But this crude formula is a good starting point, and gets us in the right mindset of understanding what opportunity cost means.
How to Find Opportunity Costs for Mission-Impact or Non-Profits
Of course, if we’re working for an organization that doesn’t have revenue, this is a different story. We might be working in a non-profit or for the government, and may have a mission-impact model where you are saving lives.
But the same principles still apply. Even if we are unwilling or unable to put a dollar amount to a life saved, when we divert resources from our core business we are missing out on the potential impact of those resources.
If our organization saves 1,000 lives per month with 10 employees, each of our employees is saving 100 lives each month.
If we assign a team member to an innovation project, that innovation project better hope to save at least 100 lives per month in the long run, or we’re wasting our resources.
Improving the Calculation
Again, this is a starting point — this crude calculation can be improved. We can differentiate between the opportunity cost of a salesperson, a customer support representative, and an engineer.
We can also consider our business model. If we’re a SaaS startup, will removing one employee will really make a difference to our revenue? Most likely not. If we’re operating at scale and almost everything is automated, removing one employee probably won’t impact anything. At least not in the short term.
In fact, for the rapid-moving tech industry, it’s almost certain that if we’re not constantly innovating then a competitor will start taking our market share immediately.
But these opportunity costs are not just for innovating or not innovating. There is a cost to moving someone from core innovation to disruptive innovation.
The point here is not to look back and see that you’ve sunk 3 months into creating the perfect opportunity cost calculation for every project. After all, what is the opportunity cost of spending all that time calculating the opportunity costs?
The point is: There are always trade-offs in resource allocation.
Don’t Invest in Innovation?
Doing this sort of calculation can be scary. The crude calculation above might make it seem like we should never invest in innovation because we’ll start losing money right away.
That is not the point.
The point is to be aware of the trade-offs represented by the opportunity cost.
For very stable companies that consistently produce returns, there is a very high opportunity cost to putting money into innovation projects. That’s why CPG companies sometimes only put 1% of their budget into disruptive innovation. (For a deep dive into the Innovation Ambition Matrix and the Golden Ratio, see Harvard University Business Review’s post on Managing Your Innovation Portfolio.)
But opportunity cost can go both ways. For companies in less stable industries, particularly companies who see a wave of disruption coming, there is a high opportunity cost of not innovating.
When we know that our industry is changing and our current business model will be obsolete soon, our Revenue per User may be high today, but zero tomorrow. Once we know that, our calculation flips radically. To not innovate is to incur the massive opportunity cost of not investing in new growth areas and technology.To NOT innovate is to incur the massive opportunity cost of NOT investing in new growth areas and technology Click To Tweet
To be fair, some public companies should not invest in innovation. They should optimize their existing business model as best they can and maximize their margins for as long as the industry lasts. Then they should quietly sell their assets and close down.
If you think this is an unusual statement, consider a company created to deliver life-saving cancer treatments. Isn’t the goal to close down that company? Wouldn’t it be a victory that there was no more demand for cancer treatments?
What would be better? If that company just focuses on making cancer treatments as cheaply as possible? Or a company that keeps its margins higher so that it can invest in adjacent ailments?
If the shareholders of this cancer treatment company or any other public company want to diversify their investment, then those shareholders are perfectly capable of putting their money on AngelList or Venture Capital firms to invest in innovative startups directly. It’s not the job of every executive to build a diversified portfolio, and not every company should be run like a hedge fund.
But for those companies that do manage large portfolios or exist in rapidly changing industries or domains, investing in innovation is a critical part of maximizing shareholder value.
The opportunity is not in business as usual, but in innovation.
Think about Opportunities
The point is not to invest our whole budget in disruptive innovation or only in adjacent opportunities. The point is to make these decisions consciously.
If we are not thinking about opportunity costs, we are making individual decisions in isolation and not thinking about our strategy and managing our innovation portfolio. We’re penny-wise, but pound-foolish.
To make great decisions about investing in innovation, we must be consciously aware of our innovation strategy, where the opportunity costs are, and how our decisions impact the rest of the company.
If you’re looking for more detail on calculating opportunity cost, contact your finance department. There are some pretty detailed things you can discuss, including:
- The cost of delay to existing projects
- Cost of capital
- The time value of money
But to keep things simple, just ask yourself, “What could innovation team members be doing with their time instead of this?”
- Good investment decisions consider opportunity cost.
- Opportunity cost is the value of what we could be doing with our resources.
- To make great decisions about investing in innovation, be conscious of opportunity costs as part of the innovation strategy.
To learn more about risk management and how opportunity costs affect your innovation strategy, check out our workshop on innovation and portfolio management.