You may have heard the phrase, “there’s no such thing as a free lunch”. It refers to the fact that even if you don’t have to pay for a meal, you still have to forego an alternative course of action. A “free” pizza means you don’t get to eat tacos. And the act of consuming the lunch will take time, which could have been spent doing other activities. Since all resources are scarce – with time being the ultimate scarce resource – every single action has a cost.
One way to implement opportunity-cost reasoning within an organization is the concept of “Economic Value Added” (EVA), a registered trademark of Stern Stewart & Company. The role of an accountant is to value assets and protect bondholders from potential bankruptcy. But what about equity holders? Joel Stern developed EVA as a student at the University of Chicago, part of a tradition in corporate finance that aimed to measure the economic value of company’s activities. Put simply, EVA is an attempt to make the hidden cost of capital more visible, allowing managers to monitor and reward genuine value creation.
The bottom line is that if a company is making less profit than it could have made doing other activities, from an economic point of view it is making a loss – even if accounting profits are high.
“Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind that it pays taxes as if it had a genuine profit. The enterprise still returns less to the economy than it devours in resources. It does not cover its full costs unless the reported profit exceeds the cost of capital. Until then, it does not create wealth; it destroys it.”Peter Drucker
In the summer of 2023 football player Lionel Messi reportedly turned down a $1.6bn contract from Saudi Arabia in order to sign for MLS side Inter Miami. The fact that he took the lower offer implies that he made an economic loss. But that doesn’t mean he isn’t earning more money than he spends, or has financial difficulties. It just reveals that “pure profit opportunities” (i.e. where opportunity costs are being fully covered) might be quite rare.
EVA isn’t perfect, and as you get lower down an organization it can become increasingly difficult to measure economic profit. This is mainly due to shared resources and transfer pricing. But the next best alternative to these sorts of measures is either arbitrary guesses, or nothing. We are always groping in the dark, but EVA is a flashlight.
These concepts can be hard to grapple with. Ultimately a “cost” of a decision is an alternative, imagined course of action.
So, economics trains us to notice important costs that we might otherwise ignore. But it also helps us to realise that some costs should be ignored. These are costs that have already occurred, and cannot be altered. Since we’ve already “paid” for these decisions, we shouldn’t take them into consideration going forwards. Doing so would constitute the sunk cost fallacy, as mentioned on ‘Better Call Saul’:
A sunk cost is incurred due to an irreversible decision, and this can turn out to be a mistake. The challenge with sunk costs is that confronting them tends to mean that you’re admitting to a previous error. Perhaps this is why the sunk cost fallacy is so pervasive – it’s a lot easier to buy some time in the hope that they turn out not to be a mistake after all, rather than admit to them and move on.
Example of the sunk cost fallacy: Concorde
The British and French governments committed over £1bn of public money to develop concorde, but only 14 were built for passenger use and operated at a significant loss.
Decision makers were faced with a difficult situation – acknowledge that the project was losing money and reallocate resources to ones that generated more economic value, or continue investing in the project in the hope that it would claw back the losses. Policymakers felt that it would be a waste to retire it, but by waiting they wasted even more resources. They should have cut their losses.
It was only after the 2000 Air France crash and September 11th terrorist attacks that Concorde was abandoned in 2003.
Managers should also be constantly vigilant for transferred costs. Economists use the term externalities to refer to situations where the decision maker doesn’t bear the full cost of their actions. They are inevitable, but have the potential to create cross-subsidization. If one department is generating costs that are inflicted on others, you get a faulty signal of value creation. We all have colleagues that impose costs on others. Whether it’s getting someone else to book their travel arrangements, or do their photocopying. An economist’s typical solution is to attempt to internalize the externality, and make decision makers bear the costs of their actions wherever possible.
EVA is a technique to help opportunity-cost reasoning permeate the company. If managers had to cover the cost of people’s time when they called a meeting, we’d probably have fewer meetings. We’d certainly have shorter, more productive ones. The point isn’t to monetize everything, but to try to make hidden costs explicit. A simple way to implement opportunity-cost reasoning is to hold meetings standing up, which tend to be substantially quicker than sit-down meetings and studies suggest that decision-making quality remains the same.
One final point to make is that costs in and of themselves aren’t bad. They are the market’s way of signalling resource scarcity. Managers should constantly be searching for hidden costs, and bringing them into the light. As we’ve seen, economic calculation helps us to do that. But because costs result from the use of factor inputs, they need to be optimized, not minimized. In other words there’s a big difference between cutting costs and eliminating waste.
When I mention this to managers, they tend to argue that when they say “cost cutting” they mean “eliminating waste”. But it’s not uncommon to see firms make cuts across the board. There’s no doubt that across-the-board cuts have benefits (for example they are quite low cost), but they reveal that you don’t know where the waste is taking place and it’s a manager’s job to understand their business well enough to ensure that across-the-board cuts aren’t necessary. On top of this, they can signal a lack of leadership. Across-the-board cuts mean that you can avoid having to make a claim about where you believe the waste is. This can be deemed “fairer”, because you’re treating everyone equally. But it also shows a lack of courage. Don’t cut costs. Eliminate waste.