I am always astounded by how many purchasing departments measure costs. They are quick to break out their spreadsheet programs to tabulate the cost of parts, labor, freight, and capital. Inept Government officials do it, too. While the cost of capital helps approximate the ever-decreasing value of money over time, it doesn't account for other hidden costs: those of transaction and opportunity.

These are my two favorite costs to talk about because they intertwine in interesting ways. I think of them differently than an accountant would.

In a sense, these two costs are sides of the same coin. They combine to form the overall cost of a choice, something I informally call decision cost. Consider buying a house. This action includes a variety of closing costs, such as realtor commissions, appraisals, title fees, and more. These are clearly transaction costs as they are not part of the product itself. The opportunity cost includes the decision to have not chosen another home, which could have been less expensive, in better condition, or any other variety of positive attributes now unavailable to you.

Now for a business example. Longtime readers know that I've discussed contentration risk regularly. Taking this idea to its natural conclusion, earning $100,000 via 10,000 customers each paying $10 would be an extreme dilution of risk. Retail business notwithstanding, imagine what it would take to manage such a large customer base. This includes relationship management, business problem familiarization, and administrative overhead to track individual sales cycles, write proposals, and the like. Clearly, these are transaction costs, some of which are quite invisible.

Now consider the opportunity cost. Instead of endless meetings with 10,000 small customers, you should be looking for larger customers who will buy more from you, and ideally in a low-maintenance way. In the US, no one wants to sort through 10,000 IRS 1099 forms. What else could you be doing with your time?

Intuition and personal experience (not mathematical rigor) suggest that transaction costs increase as the number of transactions increase. However, opportunity costs appear more parabolic and are maximized (that is, most expensive) when very few or very many actions are executed. The minimal total decision cost lies somewhere in between, and I've personally found success in the power of threes. If you write books or deliver training, find three publishers. If you are a consultant, find three loyal, long-term clients. If you're an employee, limit your concurrent project count to three.

Pursuing more opportunities increases your transaction costs, but common sense still applies. The biggest threat to controlling both of these costs is "yesmanship", a topic for another day.

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