Trade off

economic-dictionary

The trade off is the existing cost-benefit ratio of two actions. Unlike the opportunity cost, the trade off measures the benefit that we obtain by making one decision and giving up another.

Trade off is a concept used to measure the profit we get from making one decision instead of another. While opportunity cost tries to measure how much we earn and stop earning when making a decision, it focuses on the benefits that we obtain when making one decision instead of another. For example, the opportunity cost of working longer hours would be the decrease in free time. However, the trade off of working longer hours would be a higher level of income, as well as a better quality of life.

As we can see, they are two very similar concepts, but their main difference is that the trade off highlights those positive aspects that we obtain by adopting a certain decision. While the opportunity cost tries to focus on all aspects, both positive and negative.

This is a concept widely used in business management. For example, when a company decides to stop manufacturing one product line to devote all its efforts to reinforcing another. The trade off is the process by which the decision is made to decline the production of the line for a later improvement in the production of another product line.

The trade off in business management

As we said, this is a concept widely used in business management. When making decisions, the concept of trade off is often used, since it specifies the benefits that would have to adopt a decision instead of another.

To give an example, let's imagine a company that has different product lines that we will call lines 1, 2 and 3. This, when reviewing its income statement, realizes that lines 1 and 2 are generating 80% of the profit, while that line 3 generates only 20%.

Thus, the company also observes that the resources allocated to the production of line 3 prevent greater production, as well as the improvement in quality, of the other two lines, which are more profitable and with greater demand.

For this reason, the company identifies the trade off that would mean stopping manufacturing product line 3, allocating all resources to the other two lines, which are much more demanded by the market.

In this way, the trade off would be the process by which the company makes the decision to stop manufacturing line 3, thus reinforcing the other two lines and obtaining higher quality in these, as well as greater profits.

The opportunity cost, however, would take into account the loss of that 20% of income that line 3 represents, since it would stop being manufactured and could not produce any profit.

Trade off example

Taking into account the previous example, we are going to proceed to calculate the trade off. In other words, the advantages of adopting the aforementioned decision, depending on the decision finally adopted.

First, as we said, the company observes that the income statement for the different product lines reflects the following net profit result:

  1. $ 400,000.
  2. $ 400,000.
  3. $ 200,000.

When the company observes this, it decides to stop producing line 3, allocating all the resources of this to a higher production of the other two lines, as well as a higher quality in these.

After the decision and start-up, the improvement in the quality of the product leads him to increase the price of each product by € 1,000. In the same way, since it has a greater production capacity, it increases the number of products manufactured from the other two lines.

After one year, the company finds the following net profit result:

1: $ 600,000.

2: $ 550,000.

3: extinct.

With these results, the trade off of the adopted decision would be equal to the difference between the previous income statement and the first income statement, before adopting the decision to extinguish line 3.

Thus, the trade off in this case would be:

$ 1,150,000 - $ 1,000,000 = $ 150,000.

The trade off for this decision would be $ 150,000.

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