Briefly explain the following financial terms and indicate their relevance in the context of short-term management decision-making

Sunk costs are costs of a historic nature and are incurred as a result of past decisions and are therefore irrelevant to any decision-making process. Sunk costs are historical costs which cannot be changed no matter what future action is taken. Sunk costs are easily identifiable as they will have been paid for, or are owed under a legally binding contract.

Incremental costs are the changes in future costs and that will occur as a result of a decision. Ultimately if a future cost or revenue is not going to change as a result of a decision, then it is irrelevant to the decision and should be ignored in the decision-making process.

 Unavoidable costs are costs that are non incremental and thus will not change as a result of a decision. Hence they are unavoidable and should not be considered in the decision-making process. For example a hotel is considering whether to take on a special offer from a travel agent who wants to pre-book rooms at a special discount price.  The unavoidable costs in relation to this decision would be the fixed costs of the hotel as they would be very unlikely to change as a result of the decision. Thus they should be ignored in the decision-making process.

Opportunity costs occur where there are mutually exclusive alternatives from which a business must choose one. An opportunity cost is the cash benefit sacrificed in favour of a particular course of action. It is the highest alternative benefit foregone by choosing a specific course of action. Suppose a business has 3 mutually exclusive options available to it of which the net profits are, option A €100,000, option B €80,000 and option C €60,000. Since only one option can be selected, option A is chosen as it provides the biggest benefit. The opportunity cost associated with this course of action is the benefit foregone by not going with the next best alternative, option B.  Opportunity cost is an economic term rather than an accounting term.  It does not appear in the trading, profit and loss account as an expense because it represents a lost opportunity rather than an outlay cost. It is used in decision accounting as a means of presenting financial information and assessing the financial implications of a decision. For example, the decision to choose option A is not simply because it offers a profit of €100,000 but because it offers a differential profit of €20,000 in excess of the next best alternative.