Decision Making & Cost Analysis: Unavoidable, Opportunity & Relevant Costs

Core Concepts: Unavoidable, Opportunity, and Relevant Costs

1. Unavoidable Costs: The Unchangeable Burden

Definition: Unavoidable costs are expenses that cannot be eliminated or reduced in the short term, regardless of managerial decisions. These costs remain fixed even if production levels, sales volumes, or operational activities change.

Key Characteristics:

• Fixed in nature (e.g., rent, salaries of permanent staff, depreciation of machinery).
• Irrelevant to short-term decisions because they do not vary with output or activity levels.
• Must be paid even if a business shuts down temporarily (e.g., lease payments for a factory).

Example in Nepal:

• NTC (Nepal Telecommunications Corporation) must pay salaries to its permanent employees even if it temporarily suspends new customer acquisitions. These salaries are unavoidable costs.
• Daraz Nepal cannot avoid paying rent for its warehouses in Kathmandu, regardless of whether it sells 10,000 or 50,000 units in a month.

Visual: Unavoidable vs. Avoidable Costs

Unavoidable costs are sunk costs—they have already been incurred and cannot be recovered. Managers must focus on avoidable costs when making decisions like:

• Should we discontinue a product line?
• Should we outsource production?
• Should we lease or buy machinery?

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2. Opportunity Cost: The Cost of Forgone Alternatives

Definition: Opportunity cost is the potential benefit lost when choosing one alternative over another. It represents the next best option that is not selected.

Key Characteristics:

• Not an explicit cost (not recorded in financial statements).
• Subjective and depends on context (e.g., time, resources, or money).
• Critical in decision-making (e.g., investing in a new machine vs. expanding marketing).

Real-World Examples in Nepal:

1. Ncell’s Spectrum Investment:

   • Ncell spent Rs. 5 billion to acquire 4G spectrum. The opportunity cost here is the profit it could have earned if it had invested that money in expanding its fiber network instead.
   • Question: Was the 4G spectrum worth Rs. 5 billion, or could Ncell have made more money by using the funds elsewhere?

2. Khalti’s Expansion vs. Profit Reinvestment:

   • Khalti could have reinvested profits into expanding its payment gateway to rural areas, but instead chose to acquire a fintech startup in India.
   • The opportunity cost is the missed growth in rural Nepal if the startup acquisition fails.

3. Pathao’s Driver Incentives:

   • Pathao offers drivers Rs. 500/day to ride for 8 hours. The opportunity cost for a driver is the income they could earn by working at a local restaurant (e.g., Rs. 600/day).
   • If Pathao reduces incentives to Rs. 400/day, drivers may switch to restaurants, increasing Pathao’s driver turnover cost.

Worked Example: Opportunity Cost in a Kathmandu Café Scenario: A café in Thamel has a spare room that can be:

• Option 1: Rent out for Rs. 20,000/month to a local shop.
• Option 2: Use it as a coffee roasting workshop, generating Rs. 15,000/month in extra revenue.

Opportunity Cost Calculation:

Conclusion:

• If the café chooses Option 1 (renting), the opportunity cost is Rs. 15,000/month.
• If it chooses Option 2 (workshop), the opportunity cost is Rs. 20,000/month.
• Best decision? Rent out the room (higher net gain of Rs. 5,000).

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3. Relevant Costs: The Decision-Making Toolkit

Definition: Relevant costs are future costs that differ between alternatives in a decision. They are avoidable, incremental, or differential costs that directly impact the outcome.

Key Characteristics:

• Future-oriented (ignore sunk costs).
• Differential (only consider costs that change with the decision).
• Avoidable (can be eliminated if the decision changes).

Types of Relevant Costs:

Real-World Application: Nabil Bank’s Loan Decision Scenario: Nabil Bank is considering whether to approve a Rs. 5 million loan to a new restaurant in Lalitpur. The bank’s cost of funds is 10% per annum.

Relevant Costs to Consider:

1. Incremental Cost of Funds:

   • If Nabil lends Rs. 5M at 10%, it earns Rs. 500,000/year in interest.
   • But: If the restaurant defaults, the bank loses this income.

2. Opportunity Cost:

   • Instead of lending to the restaurant, Nabil could lend to a government bond yielding 12%.
   • Opportunity cost = 12% - 10% = 2% (Rs. 100,000/year).

3. Avoidable Costs:

   • If the loan is approved, Nabil incurs processing fees (Rs. 50,000) and monitoring costs (Rs. 30,000/year).
   • If rejected, these costs are avoided.

Decision Rule:

• Approve the loan only if the restaurant’s expected return > (cost of funds + opportunity cost + avoidable costs).
• Example: If the restaurant promises 15% return, Nabil should approve it because: 15% (expected) > 10% (fund cost) + 2% (opportunity cost) + (processing + monitoring costs).

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In the Real World

1. Daraz Nepal’s Warehouse Location Decision (Relevant Costs)

• Problem: Daraz wants to decide whether to open a new warehouse in Chitwan (near raw material suppliers) or expand its Kathmandu warehouse.
• Relevant Costs:
  • Incremental cost: Rs. 10M for Chitwan warehouse vs. Rs. 5M for expansion.
  • Opportunity cost: Lost sales if Kathmandu warehouse is overloaded.
  • Avoidable cost: Current Kathmandu rent (Rs. 2M/year) can be renegotiated.
• Decision: Daraz chose Chitwan because:
  • Lower transport costs for suppliers (relevant cost savings).
  • Faster delivery to southern Nepal (revenue opportunity).

2. Ncell’s Network Expansion (Opportunity Cost)

• Scenario: Ncell has Rs. 2 billion to invest. Options:
  1. 5G rollout (estimated revenue: Rs. 3B/year).
  2. Fiber expansion in rural areas (estimated revenue: Rs. 2.5B/year).
• Opportunity Cost:
  • If Ncell chooses 5G, it forgoes Rs. 2.5B/year from fiber.
  • If it chooses fiber, it forgoes Rs. 3B/year from 5G.
• Decision: Ncell prioritized 5G because the incremental revenue (Rs. 500M/year) outweighed the opportunity cost.

3. Kathmandu Traffic Police’s Patrol Route Optimization (Unavoidable vs. Avoidable Costs)

• Problem: Traffic police must decide whether to increase patrols in Thamel (tourist congestion) or expand to Bhaktapur (rising accidents).
• Unavoidable Costs:
  • Salaries of permanent officers (Rs. 50M/month).
  • Vehicle maintenance (Rs. 5M/month).
• Avoidable Costs:
  • Fuel for extra patrols (Rs. 2M/month if shifted to Bhaktapur).
  • Opportunity cost: Reduced fines in Thamel if patrols move.
• Decision: Police focused on Thamel because:
  • Higher tourist-related revenue loss (Rs. 10M/day from congestion).
  • Avoidable cost of fuel was lower than the opportunity cost of lost fines.

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How to Apply These Concepts: Step-by-Step Decision Framework

Use this 5-step process to analyze any business decision:

Worked Example: Should a Kathmandu Bookstore Discontinue Selling Old Textbooks? Given:

• Current sales: 1,000 textbooks/month at Rs. 500 each.
• Variable cost per book: Rs. 200 (printing, storage).
• Fixed costs (unavoidable): Rs. 50,000/month (rent, salaries).
• Opportunity: The store can use the shelf space for new bestsellers, generating Rs. 80,000/month.

Step-by-Step Analysis:

Decision:

• Continue selling old textbooks (Rs. 250,000 > Rs. 130,000).
• Why? The contribution margin (Rs. 300,000) outweighs the opportunity cost (Rs. 80,000).

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Comparison Table: Unavoidable, Opportunity, and Relevant Costs

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Common Pitfalls and How to Avoid Them

1. Ignoring Sunk Costs:

   • Mistake: Considering past expenses (e.g., "We already spent Rs. 10M on this machine").
   • Fix: Exclude sunk costs—they don’t affect future decisions.

2. Overlooking Opportunity Costs:

   • Mistake: Focusing only on direct costs, ignoring lost alternatives.
   • Fix: Always ask, "What else could we do with these resources?"

3. Mixing Fixed and Variable Costs:

   • Mistake: Treating all fixed costs as relevant.
   • Fix: Only avoidable fixed costs (e.g., rent if a branch closes) matter.

4. Assuming All Costs Are Relevant:

   • Mistake: Including irrelevant costs (e.g., depreciation of old machinery).
   • Fix: Use the "Will this cost change with my decision?" test.

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Exam Tip: How to Score Full Marks

1. Structured Answer Format (For Short/Long Questions)

Use this template for decision-making questions:

1. Identify the decision (e.g., "Should we discontinue Product X?").
2. List all alternatives (e.g., continue, discontinue, modify).
3. Separate relevant costs (incremental, avoidable, opportunity).
4. Calculate net impact (revenue - relevant costs).
5. Compare and conclude (which option is best?).
6. Justify with real-world logic (e.g., "Since opportunity cost is higher, we should...").

2. Key Terms to Define (For Theory Questions)

• Unavoidable Cost: "Costs that cannot be eliminated in the short term, such as rent or fixed salaries."
• Opportunity Cost: "The benefit sacrificed when one alternative is chosen over another, e.g., not expanding to Pokhara means missing Rs. X in sales."
• Relevant Cost: "Future costs that differ between alternatives, used to make optimal decisions."

3. Numerical Problems: Step-by-Step Approach

For questions like: "A company has two options: Option A costs Rs. 100,000 with revenue Rs. 150,000; Option B costs Rs. 80,000 with revenue Rs. 120,000. Which is better?"

Your Answer Should Include:

1. Calculate contribution margin for each option.
   • Option A: Rs. 150,000 - Rs. 100,000 = Rs. 50,000
   • Option B: Rs. 120,000 - Rs. 80,000 = Rs. 40,000
2. Identify opportunity cost (e.g., "If we choose A, we forgo Rs. 40,000 from B").
3. Compare net benefits and conclude.

4. Real-World Application (For Case Studies)

• Always tie your answer to a Nepali business (e.g., "Like Ncell’s 5G decision, this company should...").
• Use local examples (e.g., Daraz’s warehouse, Khalti’s expansion).

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5. Common Exam Mistakes to Avoid

❌ Not separating relevant from irrelevant costs. ✅ Always ask: "Will this cost change with my decision?"

❌ Ignoring opportunity costs. ✅ Explicitly state the forgone benefit (e.g., "By not expanding, we lose Rs. X in sales").

❌ Assuming all fixed costs are unavoidable. ✅ Check if any fixed costs can be avoided (e.g., rent if a branch closes).

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Final Checklist Before Submitting

✔ Did I define all key terms clearly? ✔ Did I separate relevant costs from irrelevant ones? ✔ Did I calculate opportunity costs explicitly? ✔ Did I compare alternatives logically? ✔ Did I use a Nepali business example where possible?

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Remember:

"The art of decision-making lies not in finding the perfect answer, but in choosing the least bad option while minimizing opportunity costs." — Adapted from Cost Management Principles.