Second-year student Rohan Rajiv is blogging once a week about important lessons he is learning at Kellogg. Read more of his posts here.
Let’s take a situation where a firm decides to buy a smaller technology firm for $1 billion.
Every decision that is made is typically the result of a cost-benefit analysis. In some cases, this analysis is entirely quantitative. In others, it has a huge qualitative element (e.g. fit with strategy). Either way, the costs of the acquisition are not just the cost of acquiring the company. Those are just the financial costs.
The costs that should matter to us are the economic costs of the acquisition, driven by the opportunity cost of using that capital. In this case, the acquiring company had three options on how to spend the billion dollars related to that acquisition (there are options beyond this, but we’ll assume the acquisition was critical):
- Build the technology
- Partner with the technology company to get access to it
- Acquire it
When we take these options and their opportunity costs into consideration, the only way we get to option No. 3 is if we believe that it is the best use of the $1 billion. Or, put differently, had we invested the billion dollars into options 1 or 2, the long-term results would be sub-optimal.
Understanding opportunity costs is fundamental in life just as it is business. At any given time, saying “yes” to a decision just because it provides us some benefit is a really bad way to make decisions. The way to make such decisions is to ask, “Is this the best possible use of my time given all my priorities?”
Great strategy requires us to make choices after understanding tradeoffs. And having a good decision making process that considers opportunity costs is an integral part of great strategy.
Rohan Rajiv is a second-year student in Kellogg’s Full-Time Two-Year Program. Prior to Kellogg he worked as a consultant serving clients across 14 countries in Europe, Asia, Australia and South America. He interned at LinkedIn in Business Operations and will be heading back to LinkedIn full-time after he graduates in June 2016. He blogs a learning every day, including his MBA Learnings series, on www.ALearningaDay.com.