Opportunity risk occurs whenever there’s a possibility that a better opportunity may become available after having committed to an irreversible decision.
We all experience opportunity risk at its most basic level several times a week. For example, imagine you have enough cash on you for lunch in a new town and you’re trying to decide between two restaurants you’ve never tried. What if you spend your time and money on the first option and it’s terrible? Or even maybe it’s not terrible, but the second option is just so much better?
Opportunity risk is what you’re contemplating as you stand there running out of time between meetings with your stomach is growling.
In the context of financial business processes, opportunity risk is most often expressed as the time value of money. In other words, are you able to use cash in its most economically efficient way?
The use of funds in a manner that leads to the loss of economic value includes:
- Time value losses due to delays in invoicing, order processing, collections, claim processing, investment of funds, etc. The consequences of these delays could result in some subsidiaries borrowing while others are investing.
- Transaction costs due to inappropriate or inefficient management of cash flows. For example, the need to borrow high-cost funds or sell securities at a loss, because of the failure to match the maturities of short-term investments to settlement dates on operational or financial obligations.
- Indifference to yield-enhancement strategies and ineffective yield-curve management. Earnings exposure may exist when funds are invested in a manner that does not generate sufficient returns to cover costs, profits and risk. Investment losses may result from the failure to obtain return, which compensates for the degree of risk which is incurred.
Loss of value may also occur when cash moves through the financial system and/or is transferred across borders.
Economists use the term "opportunity cost" to describe the invisible loss that comes from missing out on a chance to generate a higher return. As expressed above, the biggest problem businesses face is time value loss. For instance, assume a company invested its money in bonds at a 6% interest rate. If it was found later that the money could have been invested in mutual funds with a 10% return, then the opportunity cost would be 4%.
BUSINESS RISKS RELATED TO OPPORTUNITY COST
Failure to manage opportunity cost risk can have the following impact:
- Loss of foregone economic funds
- Time value losses
- High or additional transaction costs
- Earnings exposure
- Declining sales or profits
- Competitive position may erode over time
- Exposure to an income loss
- Missed business opportunities
ROOT CAUSES OF OPPORTUNITY COST RISK
Sourcing the root causes requires an analysis of the key business processes that influence the cash-to-cash cycle. Analysis of business processes can be comprehensive or selective depending on management's view of where the risks and opportunities for improvement are. When analyzing business processes, look for areas where cash flow is delayed, funds are left idle or cash transfer and handling costs are excessive.
Take a look at the processes for Order entry and processing, invoice processing receivable management and collection processes. Are these all being handled in an efficient manner or is there lag that causes funds to sit idle or even fail to be collected in a timely fashion?
For more information on the root causes and important questions to consider, check out the Opportunity Cost Risk Key Performance Indicators benchmarking tool on KnowledgeLeader.
And while you’re there, you may also be interested in these other related areas: