Calculating the Opportunity Cost of Unfilled Jobs
What does an unfilled job cost?
We all know that recruiters are expensive. What is less often talked about is the cost of leaving a position open.
There are a few reasons we don't think of opportunity cost as often. For one, it's hard to precisely quantify. This is especially true the smaller or younger a company is.
Second, opportunity cost is theoretical and exists in the future whereas the cost of hiring is real and hits your balance sheet today.
Business operators are wise to focus on the reality of today's cash flow when it comes to hiring. That said, growing a business is about making investments and hiring the right people is undoubtedly one of the best investments you can make.
Let's talk about simple ways to get a handle on calculating the return on investing in a new hire, or said another way, the opportunity cost of not making a hire.
Calculating opportunity cost
Like any financial modeling, calculating the opportunity cost of an open job is both an art and a science.
We've seen wildly complex models for Private Equity buyouts and large, fast-growth corporations. We've seen simplistic scratch math. What the best models all have in common is they accurately answer or predict these questions:
- How much revenue is the company generating?
- How much cash flow is the company generating?
- How fast is the company growing?
- How much value does a given role create?
- On what timeframe is value created?
Think of these questions as a checklist of sorts. The more questions you can answer and the greater your accuracy, the more predictable your investments in head count are.
Believe it or not, most companies only really have a grasp on questions 1 and 2. Forward-looking growth rate, value creation by job, and the timescale of value creation are often guesstimates. Remember, public companies miss earnings roughly 30% of the time.
With that in mind, here's a simple approach to calculating opportunity cost that's surprisingly accurate in most cases.
Calculating a base rate
The first step to calculating opportunity cost is starting with the facts. For all but new startups, last year's revenue and employee head count are easy facts to work with. When you divide the latter by the former you get an average that is a good starting point to understanding just how valuable a role is.
Revenue / Employees = Opportunity Cost
Let's look at two examples:
Small company (2017): $3.2M annual revenue / 19 employees = $168k revenue per employee
Amazon (2017): $177B annual revenue / 566k employees = $312k revenue per employee
Now obviously, because we're dividing by all employees we're ending up with an average that is going to be understated or overstated for any given job type.
For instance, it would be a mistake for Amazon to assume that hiring a new customer service agent or warehouse worker will result in $312k of additional revenue. Likewise, some positions are more value than the average.
Discounting or multiplying
Now that we have a base rate, we need adjust it to reflect the type of job we're evaluating. There are lots of way to arrive at discounts or multiples of this base rate but one of the simplest and most reliable (read, conservative) is indexing your pay scale to your highest salary.
Let's use a restaurant with three types of employees:
- Servers who make $35k a year
- Cooks who make $45k a year
- Managers who make $50k a year
By dividing any of these salaries by the highest salary you end up with a discount that can be applied to the base rate.
(Salary / top salary) x Revenue per employee = Discounted opportunity cost
For example, let's say this restaurant makes $85k per employee. The discounted opportunity cost for a server would be $56k per year.
($35k Server salary / $50k Top salary) x $85k = $56k per year in opportunity cost.
I prefer this method because it's conservative and it uses the wisdom of markets, in this case the market for labor and the corresponding market rates for different job types.
It also encourages you to think of your employees as a system working together rather than individual silos of value creation. Remember, great businesses get 1 + 1 to equal 5.
What about multiples? My advice for headcount planning is to only use a discount. It's far better to understate the value and be wrong than to overstate it and be wrong.
Now that you have a discounted opportunity cost you can see how much theoretical money you're leaving on the table with an open position.
(Discounted opportunity cost / 365) x time-to-fill = opportunity cost of an unfilled position
Let's look at the opportunity costs of unfilled jobs using some market averages :
Customer service: 20 days to fill x discounted opportunity cost = $2k - $6k
Data scientist: 70 days to fill x discounted opportunity cost = $38k to $100k
Why calculate opportunity cost?
Of all the things you can model for your business, the opportunity cost of unfilled jobs is probably not business critical. But as a lightweight exercise it does have a few benefits.
- It can be a gut check on your hiring plans by highlighting the assumptions you're making about your business. For instance, if you end up with negative opportunity costs then you need to think extra hard about the assumptions you're making about revenue growth.
- It helps your recruiters think of their work in terms of business impact by connecting headcount to expected revenue, and time-to-fill to both realized cost and opportunity cost.
- It's an added component to understanding the cost of your recruiting function and how well it's performing by connecting the time it's taking to fill jobs with the opportunity cost of leaving them unfilled.
A final thought
The opportunity cost of an unfilled job is often used to sell third-party recruiting services. That's because generally speaking, the cost of an unfilled position is greater than the fee a recruiting service charges.
That's not why I wrote this article though.
As a business operator myself who has hired in fast-growth companies, turnaround situations, and startups, I think the exercise can provide insight to both operators and recruiters about the cost of hiring, the cost of not hiring, and the importance of speed in the recruiting process.
I hope this article was helpful and interesting. As always, if you have comments or questions we'd love to hear from you. You can contact us here.