From the Farm to the City

We now know how Farmer Jones used opportunity cost to make his planting decisions. But what about his city cousin, who was in the manufacturing business? Did he do things differently? Let's find out.

I have a friend who is the chief financial officer of a megasized manufacturing company. This company has factories located in different towns and cities throughout the United States. It also has production facilities other countries.

While fishing for big-mouth bass several years ago, I asked my friend how his company decided what products to produce and what product not to produce. His response was informative.

He told me that, like General Motors or the comer doughnut shop, his company had a limited amount of resources at its disposal (our legacy from Adam and Eve). He also said that his company was making a pretax rate of return of no less than 14 percent on all existing products it was manufacturing. He referred to this 14 percent as an internal rate of return or target rate of return.

He went on to say that any manager who wanted to introduce a new product for manufacture had to demonstrate that the project would yield a rate of return equal to or greater than 14 percent. If he or she couldn't, the project was rejected because it would be an inefficient allocation of the company's resources.

Like Farmer Jones, when this company was comparing rates of return between new products and existing products, it was calculating the opportunity cost associated with using resources to produce product "a" versus product uct "b" or "c." And, like the planting decisions of Farmer Jones, the manufacturing operation of this company was driven by its opportunity cost.