Decision-Making Tools: Opportunity, Relevant & Unavoidable Costs

TAKEAWAYS:

• Opportunity cost is the benefit lost by choosing one option over another (e.g., renting a shop vs. expanding production).
• Relevant costs are future costs that differ between alternatives (ignore sunk costs and unavoidable costs).
• Unavoidable costs cannot be changed by a decision (e.g., fixed rent for a leased factory).
• Use incremental analysis to compare total costs/revenues of alternatives.
• Decision traps: Avoid ignoring opportunity costs or mixing relevant/irrelevant costs.
• Real-world tie: Kathmandu’s traffic congestion (opportunity cost of time) or Ncell’s network expansion (relevant costs of new towers).

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1. Opportunity Cost: The Hidden Cost of Choices

Definition: Opportunity cost is the potential benefit forgone when one alternative is chosen over another. It is not a recorded cost but a conceptual cost that helps evaluate trade-offs.

How It Works

• Example: A farmer has 10 hectares of land. If they grow rice (profit: Rs 500,000), the opportunity cost of growing wheat (profit: Rs 400,000) is Rs 100,000 (the difference).
• Key Idea: Every decision has an implicit cost—what you could have earned instead.

Visual: Opportunity Cost in Kathmandu Traffic

Caption: A driver’s Rs 2,000/hour wage is lost during 20 minutes of traffic. That’s the opportunity cost of poor road planning.

Worked Example: eSewa’s Payment Routing

eSewa processes 50,000 transactions/day. If they route payments through Nepal Rastra Bank (NRB) (delay: 2 hours, fee: Rs 5/transaction) vs. Fintech Partner X (delay: 30 mins, fee: Rs 10/transaction), the opportunity cost of using NRB is:

• Lost revenue: 2 hours × Rs 50,000 (daily volume) × (Rs 10 – Rs 5)/transaction = Rs 500,000/day.
• Decision: Partner X is better despite higher fees because time saved generates more business.

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2. Relevant Costs: The Only Costs That Matter

Definition: Relevant costs are future costs that differ between decision alternatives. They include:

• Incremental costs: Additional costs of choosing one option (e.g., buying a new machine).
• Differential costs: The change in cost between alternatives (e.g., Rs 500 more for a premium supplier).
• Opportunity costs: Benefits lost (e.g., renting out unused space).

What’s Not Relevant?

Visual: Relevant Cost Filter

Caption: Only future, differing costs matter. Past costs (sunk) and fixed costs (unavoidable) are ignored.

Worked Example: Daraz’s Warehouse Decision

Daraz is deciding whether to lease a new warehouse in Lalitpur (cost: Rs 2,000,000/year) or expand existing storage (additional cost: Rs 500,000/year + Rs 300,000/year for overtime labor).

• Relevant costs:
  • Lease: Rs 2,000,000 (future, differs).
  • Expand: Rs 800,000 (future, differs).
• Unavoidable cost: Existing warehouse rent (Rs 1,500,000) is irrelevant—it’s paid either way.
• Decision: Expand if overtime labor doesn’t exceed Rs 1,200,000/year.

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3. Unavoidable Costs: The Fixed Burden

Definition: Unavoidable costs are fixed costs that cannot be changed by a short-term decision. Examples:

• Rent for a leased factory.
• Salaries of permanent staff.
• Depreciation on existing machinery.

When Do They Become Relevant?

• Short-term: Ignore unavoidable costs (e.g., keep a factory open if variable costs < revenue).
• Long-term: All costs become relevant (e.g., closing a factory requires selling the land).

Visual: Unavoidable vs. Avoidable Costs

Caption: Unavoidable costs are sunk in the short run but may become relevant later.

Worked Example: Ncell’s Network Tower Decision

Ncell is deciding whether to shut down a tower in Pokhara (serves 5,000 users) or upgrade it.

• Unavoidable costs:
  • Land lease: Rs 2,000,000/year.
  • Existing tower depreciation: Rs 1,500,000/year.
• Avoidable costs:
  • Maintenance: Rs 500,000/year (can be cut if tower is shut).
  • Staff salaries: Rs 300,000/year (can be reassigned).
• Revenue: Rs 10,000,000/year from Pokhara users.
• Decision: Shut down only if variable costs (Rs 800,000) > revenue (Rs 10M)—here, keep the tower open.

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4. Decision-Making Tools in Action

Tool 1: Incremental Analysis

Compare total costs and revenues of alternatives, focusing only on relevant costs.

Example: Should Hotel Himalaya (Kathmandu) add a spa?

• Current revenue: Rs 20,000,000/year.
• Current costs: Rs 15,000,000 (unavoidable) + Rs 3,000,000 (variable).
• Spa addition:
  • Revenue: +Rs 5,000,000.
  • Costs: +Rs 2,000,000 (staff) + Rs 1,000,000 (equipment).
• Incremental profit: Rs 5M – (Rs 2M + Rs 1M) = +Rs 2,000,000.
• Decision: Add the spa.

Tool 2: Make-or-Buy Analysis

Decide whether to produce in-house or outsource.

Example: A Kathmandu furniture maker can buy chairs for Rs 1,200 each or make them (costs: Rs 800 wood + Rs 300 labor + Rs 100 overhead).

• Buy: Rs 1,200.
• Make: Rs 1,200.
• But: If the factory has idle capacity, the opportunity cost of making chairs is Rs 0 (no lost revenue from alternative use).
• Decision: Make in-house (same cost, but avoids supplier risks).

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5. Common Decision Pitfalls

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6. Real-World Applications

In the Real World

1. eSewa’s Payment Routing

   • Tool: Opportunity cost.
   • How: eSewa compares transaction fees vs. time delays. Faster processing (even with higher fees) generates more repeat business.

2. Daraz’s Warehouse Location

   • Tool: Relevant costs.
   • How: Daraz evaluates shipping costs (relevant) vs. rent (unavoidable if the warehouse is already leased).

3. Ncell’s Network Expansion

   • Tool: Incremental analysis.
   • How: Ncell calculates the additional revenue from a new tower in Biratnagar vs. the cost of new equipment and staff.

4. Kathmandu Traffic Congestion

   • Tool: Opportunity cost.
   • How: The Rs 5,000/hour lost by commuters stuck in traffic is the opportunity cost of poor urban planning.

5. Nepal Rastra Bank’s Forex Reserves

   • Tool: Relevant costs.
   • How: NRB decides whether to buy more USD (cost: Rs 130/USD) based on future demand (relevant) vs. holding costs (unavoidable).

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Exam Tip

1. Spot the question type:

   • "Should we shut down?" → Focus on avoidable costs vs. revenue.
   • "What’s the opportunity cost?" → Calculate the next-best alternative’s benefit.
   • "Which costs are relevant?" → Future + differing only.

2. Structure your answer:

   1. Identify decision alternatives (A vs. B).
   2. List all costs/revenues.
   3. Highlight **relevant costs** (future, differing).
   4. Ignore **sunk/unavoidable costs**.
   5. Calculate incremental effect.
   6. State clear recommendation.
   

3. Common exam traps:

   • Don’t include depreciation of old assets (sunk).
   • Don’t forget opportunity costs (e.g., lost rental income).
   • Do show calculations—examiners reward step-by-step logic.

4. Numerical questions:

   • Always label units (e.g., "Rs 500,000/year").
   • Use tables for clarity:

5. Memorize key terms:

   • Sunk cost: "Water under the bridge."
   • Relevant cost: "Future and differing."
   • Opportunity cost: "What you give up."