DIFFERENTIAL COSTS

I. Two Fundamental Questions

§ What activities (thus, costs and revenues) differ among the alternatives?
§ How does that difference affect operating profits?

II. The Differential Principle

Managerial decision-making is choosing among alternatives or options. Each

represents a set of activities that will result in costs and revenues.

A differential cost is that whose amount changes as a result of changing activities or

levels of activity. The same concept applies to differential revenue.

A. Relevant Costs

Differential costs analysis is also called relevant costs analysis as it identifies the
costs (and/or revenues) that are relevant to the decision to be made.

B. Focus on Cash Flows

The emphasis on cash flows is fundamental for two reasons:

1. Cash is the medium of exchange.

2. Cash is a common, objective measure of the benefits and costs of alternatives.

Consequently, differential analysis focuses mostly on differential cash flows due to

changes in activities.

C. Uncertainty and Differential Analysis

When considering options, the types, levels, and costs of activities are all estimates
and subject to error. Cost and revenue estimates for the status quo are usually
more certain than estimates for alternatives.

Managers typically avoid too much risk and bear it only if compensated. Thus, the
manager may reject, because of risk, an alternative expected to be more profitable
than the status quo.

With the rule of maximizing profit, removing non-relevant costs/revenues from the
analysis will provide the same quantitative conclusion as not removing them.
Thus, removing non-relevant items will avoid/minimize information overload’s
adverse effects.

Sunk costs (those already incurred or committed to be incurred) are a form of non-
relevant costs. A manager making a bad decision sometimes feels like the decision
will become a good one – if he throws enough money at it!

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 NB: Qualitative and strategic (also long run) considerations are to be recognized in
making the final decision. Those issues can override quantitative and/or financial
justifications.

III. Major Influences on Pricing

A. Customers.
B. Competitors.
C. Costs

In making pricing decisions, companies weigh customers, competitors, and costs

differently. In a highly competitive market, the market sets the price. When there is
little competition the manager has more discretion.

Pricing is an area where newly evolving themes, such as customer satisfaction,

continuous improvement, and the dual internal/external focus come together.

Over which of the three influences do managers have better control and
understanding?

IV. Differential Approach to Pricing

The differential approach to pricing is useful for short run and long run decisions and
presumes the price must at least equal the differential cost of producing and selling.

In the short run, this will result in a positive “differential” contribution margin. Both
fixed and variable costs are differential in the long-run, requiring covering all costs.

V. Long-Run Pricing Decisions

Many firms rely on full-cost information when setting prices. Full-cost, the total cost of
producing and selling a unit, includes all costs incurred in the value chain.

VI. Product Choice Decisions

One of the most important decisions is which product(s) to make/provide. In the short
run, capacity limitations will sometimes affect this decision.

Because many accounting systems provide unit cost information, including allocation
of fixed costs, short-run decisions can be incorrect. This is especially likely with
systems using full-absorption costing.

VII. Make-or-Buy Decisions

A make-or-buy choice decides how to satisfy company needs – internally or from

external sources (outsourcing).

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VIII. Joint Products: Sell or Process Further

Joint product decisions deal with multiple products from a single production process.

Split-off point is that where identifiable products emerge. Costs before split-off are
joint costs and costs after are additional processing costs. The manager must decide
at split-off whether to sell or process further. Differential analysis is appropriate for
this decision.

IX. Adding and Dropping Parts of Operations

Managers must decide when to add or drop products and when to open or abandon
territories. While this is another example of a decision that has tremendous long run
implications, the impact on current profits can also be calculated using differential
analysis.

The decision rule is: If the differential revenue of the product/territory exceeds the
differential costs to have the product/territory, the product/territory should be
maintained or developed.