Opportunity cost is applicable to companies’ decisions on supplier selection. The decision to order components for production from China instead of local suppliers is a classic example where opportunity cost plays an important role.
What is opportunity cost?
Opportunity cost is the value of the best alternative not taken. In simple terms, it means the ‘price’ of the choice we incur by giving up another option. For every decision, a company or individual considers the potential benefits and costs it could achieve by choosing to do something else.
We can compare this to the everyday choice between two attractions – for example, you go to the cinema or you go to a concert. If you choose to go to the cinema, the opportunity cost is the enjoyment you might have experienced at the concert you did not choose.
Opportunity cost when choosing a supplier – local vs. foreign
Now imagine that a company manufactures electronic devices and is considering whether to order components from China or from local suppliers.
Purchasing cost – Components from China can be cheaper than from local suppliers, which reduces production costs. However, the lower price of components is not the only factor a company should consider, as this is where opportunity cost comes into play.
Opportunity cost in the supplier decision – When a company decides to order components from China, it foregoes local suppliers, which involves certain opportunity costs. These include:
Delivery time – Deliveries from China can take longer, which can delay production or increase the need to plan well in advance. The opportunity cost in this case is the value the company loses by not being able to respond quickly to changes in demand that it could gain by having a supplier closer.
Quality and delivery risk – Components ordered from afar may be more prone to damage in transit, delays associated with international logistics or quality control problems. The opportunity cost here is the possibility of greater control over quality that a local supplier would give.
Support for the local economy and business relationships – Using local suppliers can build a positive reputation for supporting the local economy. The opportunity cost here is the loss of local benefits, such as better business relationships and a positive corporate image, which can be beneficial in the local market.
Stability of the supply chain – In the event of international trade disruptions (e.g. customs problems, currency market situation or changes in trade policy), the company may incur additional costs. By choosing a local supplier, the company reduces the risk associated with the uncertainty of international supply. The opportunity cost is the stability that a local supplier would offer.
Summary: Example of opportunity cost
By choosing to order from China, a company gains a lower cost of components, but incurs an opportunity cost by giving up the benefits that a local supplier would have offered. The opportunity cost is therefore not a directly financial value – rather, it is the sum of the potential benefits the company could have achieved by making a different decision.
Each company needs to assess whether the financial savings of buying cheaper components outweigh the benefits that would be gained by working with local suppliers.
