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Discussion Forum Unit 4
Discussion Forum Unit 4
May 4, 2021
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Introduction:
At some point in a company’s lifetime, the “Make or buy” question usually comes up within
an organization. A decision is usually derived from carrying out a differential analysis which
compares the associated costs and profits between various options. The evaluation is confined
to only factors that are different among possible alternatives and usually follow 4 steps –
compute all associated costs, ignore sunk cost, ignore constant cost, select alternative with the
In computing the costs, the relevant and irrelevant costs applicable for differential analysis
should be identified. For Goodyear tire these will include: Irrelevant costs: these are costs
that remain fixed irrespective of the decision made. - Cashflow from operating activities -
Sunk costs - Research and development costs on unsuccessful products - Restructuring costs -
Allocated fixed cost – fixed costs that cannot be traced directly to a product or customer
There are similar costs associated with differential analysis for a customer or a product: -
Sales revenue - Variable costs - Contribution margin - Direct fixed cost – fixed cost that can
be traced directly to a product line or customer Processing or selling joint products – two or
more products can result from a common material – will the company focus on one or both?
Some by- products can also be discarded or processed further to achieve another product
Sunk costs are costs that have already been spent by a company that cannot be recovered. In
the case of At some point in a company’s lifetime, the “Make or buy” question usually comes
analysis which compares the associated costs and profits between various options. The
evaluation is confined to only factors that are different among possible alternatives and
usually follow 4 steps – compute all associated costs, ignore sunk cost, ignore constant cost,
select alternative with the best cost to benefit ratio (Differential Analysis)
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In computing the costs, the relevant and irrelevant costs applicable for differential analysis
should be identified. For Goodyear tire these will include: Irrelevant costs: these are costs
that remain fixed irrespective of the decision made. - Cashflow from operating activities -
Sunk costs - Research and development costs on unsuccessful products - Restructuring costs -
Allocated fixed cost – fixed costs that cannot be traced directly to a product or customer
There are similar costs associated with differential analysis for a customer or a product: -
Sales revenue - Variable costs - Contribution margin - Direct fixed cost – fixed cost that can
be traced directly to a product line or customer Processing or selling joint products – two or
more products can result from a common material – will the company focus on one or both?
Some by- products can also be discarded or processed further to achieve another product
Sunk costs are costs that have already been spent by a company that cannot be recovered. In
the case of Goodyear tire, these will be costs associated with activities like Research and
Development for a new product that proved unsuccessful. These costs should not be
considered in differential analysis as no actions can reverse them. Opportunity costs are
forgone costs/benefits of selecting one choice over another. While they are not reflected in
accounting records, they must be considered when performing differential analysis as they
References:
https://xplaind.com/478812/differential-analysis
Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for Managers. Retrieved from
https://2012books.lardbucket.org/books/accounting-for-managers/index.html
managacct/chapter/differential-analysis-and-its-application-to-managerial-decision-making/
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DIFFERENTIAL ANALYSIS
Typically differential revenues and costs differ from one alternative to another are included
and must be considered in differential analysis, whereas non-differential costs are costs that
remains constant or the same to all alternatives can be excluded. Types of financial data of
differential analysis for Lam Research:
Included – values differ in each alternatives Excluded – values are constant in all
alternatives
Avoidable Costs
Opportunity Costs
Profit
The following specific revenues and costs should be considered in differential analysis
related to drop or keep Customers or Product Lines for Lam Research.
Revenues Revenues
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Opportunity Costs
Profit
Sunk costs are costs in the past that is unrecoverable and irrelevant in decision making
because it is already incurred, hence these costs cannot be changed all across alternatives,
(Hermanson et al., 2006). A likely example in Lam Research would be a purchased machine
or equipment for a dedicated product line that flopped or did not take off, the amount
spend on this machine then becomes a sunk cost because it cannot be taken back.
Opportunity costs is the potential benefit that did not occur and does involve any cashflow,
it reflects a real sacrifice (lost opportunity) when one alternative is selected over another,
(Hermanson et al., 2006). A likely example in Lam Research would be using a production
space to do an outsourced assembly in-house to reduce costs, however if that same
production space could have been used for additional product line it would have added a
substantial net income to the company which is now a lost opportunity.
Opportunity cost is not recorded in accounting records but is still relevant and should be
considered in differential analysis because it reflects a real sacrifice (lost opportunity) when
one alternative is selected over another, (Hermanson et al., 2006). Sunk costs on the other
hand are seen as “irrelevant to current and future budgetary concerns” thus not necessarily
considered in differential analysis, (Tuovila, 2021).
Heisinger, K., & Hoyle, J. (n.d.). Accounting for Managers. Retrieved April 10, 2021, from
https://2012books.lardbucket.org/books/accounting-for-managers/
Warren, C. S., Reeve, J. M., & Duchac, J. E. (2016). Financial & Managerial Accounting (13th ed.).
Cengage learning
Introduction
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Differential analysis simply involves analyzing the different costs and benefits that would
arise from alternative solutions to a particular problem (www.lumenlearning.com). Unilever
Ghana Company Limited has many opportunities to use differential analysis in their
business ranging from outsourcing manufacturing staffing, research for new product
processes as well as outsourcing the process of introducing new methodology of their
products into their global market. To determine if Unilever Ghana should change their
current noble customers (purchasing their products), they would utilize a differential
analysis process to help them make the most informed decision.
Discussion
Financial Data (differential analysis): The difference in costs with an alternative plan of
action than what’s currently being followed, and the analysis of those variations is called a
differential analysis (Heisinger, 2012). Creating a model of the current state and comparing
that to the proposed options allows you to determine the differential amount to help guide
your decision.
Included: Sales revenue and total production costs would be used to calculate the
contribution margin and profit variation in a differential analysis.
Sales revenue: Current sales vs. sales if Unilever Ghana eliminates the product
customer.
Total production costs including variable costs (direct materials, direct labor, and
manufacturing overhead), fixed costs (supervisor salaries, building rent, and
equipment leases).
Excluded: Unilever Ghana should not include sales or expenses which are not related to the
product being discussed when. For example, Unilever’s manufacturing processes and
services program revenue and expenses would not be included in a differential analysis of
this kind.
Comparing the options in a differential analysis, the alternative with the highest calculated
profit would be the recommended decision.
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Product Line: Unilever may want to determine if keeping a specific manufactured
product and should pull financial data for each product line to compare against
one another. Compared to a customer evaluation, eliminating a specific product
from their offering would have direct fixed costs that may be eliminated such as
R&D expenses, warehouses and supervisor salaries are dedicated to the specific
product manufactured. Allocated fixed costs, however, such as rent on larger
warehouse and C-level salaries would not be reduced and are utilized for
multiple product lines. Unilever Ghana may have some opportunity costs, may
also be evaluated if Unilever was able to rent out their current warehouses for
profit.
Sunk cost
A sunk cost is a cost that an entity has incurred, and which it can no longer recover. Sunk
costs should not be considered when making the decision to continue investing in an
ongoing project, since these costs cannot be recovered. As sunk costs are historical costs
these are incurred in the past and not relevant for decision making purpose. For example,
R&D costs, Feasibility report costs etc.
Opportunity Costs
These are considered in decision making analysis. In simple terms opportunity cost means
the loss of other alternatives when one alternative is chosen (Heisinger, 2012).
Costs should be considered in the differential analysis and explain why and why not
The differential cost analysis is a useful tool for the management to know the results of any
proposed changes in the level or nature of activity. Under this method, the differential costs
are ascertained for each proposal and compared with the expected changes in revenue
associated with each proposal. Sunk costs incurred in the past that cannot be changed by
future decisions are not differential costs because they cannot be changed by future
decisions (Press Released, 2019).
Resources
Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for Managers. Retrieved from
https://2012books.lardbucket.org/books/accounting-for-managers/index.html
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https://courses.lumenlearning.com/managacct/chapter/criteria-used-in-
managerial-decision-making/
Energizer Holdings Inc.(EHI) does 2.7 billion USD in net sales according to their 2020
annual proxy statement. (Annual Report | Energizer Holdings, Inc., 2020). To
continue their sales, EHI may make use of differential analysis which can weigh” all
the potential solutions to a particular business opportunity to determine which one
is the most cost-effective” (Berman, 2017). Looking at revenue and cost we can
determine the profitability of one particular product or customer and in turn
eliminate those that generate less revenue than we expect. Overall the process of
differential analysis will help EHI management make informed decisions about
products and customers with the goal of continual increase in net profit.
In an evaluation to keep or eliminate a customer EHI should think about both
quantitative and qualitative factors. Initially they would find differential revenues and
costs of two or more scenarios, that would be the costs that differ between
alternatives. The analysis would consider the variable and direct fixed costs related
to each customer and the overall impact on the bottom line. Allocated fixed costs are
costs that cannot be traced to one customer; they will be spread out among all
customers. Allocated fixed costs are not differential and could include insurance,
utilities or taxes. In evaluating whether or not to keep a customer EHI would also
want to look at how much money goes into acquiring customers, providing products
and support and maintaining the relationship (Heisinger, K., & Hoyle, J. B. (n.d.).
Similarly in evaluating whether or not to keep a product line EHI would evaluate
the product line income statements. Direct fixed costs related to the product line
would be a differential cost that would be eliminated if the product line were
eliminated. Those costs may be salaries or direct labor or material related to the
product line. Again, allocated fixed costs, which may be the cost of leasing a building
may be spread across multiple products. If one product is eliminated those costs still
need to be covered by other products.
Any sunk costs that Energizer Holdings Inc have incurred would not be
considered in differential analysis because any future decisions would not affect
those past costs. Battery making material or machinery from a discontinued line of
batteries would be considered sunk costs.
Opportunity costs EHI may find can be considered in a differential analysis
because that may affect the overall management decision. If we are deciding to keep
or discontinue AAA batteries but I can use the already purchased material to make D
batteries that would be considered an opportunity cost if we keep the AAA battery
line. It's possible the opportunity cost could sway a decision on keeping or
eliminating a product.
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Annual Report | Energizer Holdings, Inc. (2020, November 17). Energizer Holdings -
Investors. https://investors.energizerholdings.com/annual-report
Berman, C. (2017, November 21). What Are Some Examples of Differential Analysis in
Accounting? Small Business - Chron.Com.
https://smallbusiness.chron.com/examples-differential-analysis-accounting-
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81985.html
Differential cost analysis is the increase or decrease in total cost pf the change in specific
elements of cost that result from any variation in operations. It represents an increase or
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decrease in total cost resulting out of
costs and opportunity costs are considered. Fixed costs and fixed portion of semi-variable
3. Contribution from other profitable products which is proposed to be produced with the
spare capacity will be considered. Avoidable fixed costs are considered, as these can be
avoided when product or customer is shut down. Avoidable fixed costs divided by the PV
ratio will give level of sales below which it is better to shut down.
Because these costs will be incurred even though the product discontinued.
Sunk Costs: A sunk cost is a cost that an entity has incurred, and which it can no longer
recover. Sunk costs should not be considered when making the decision to continue
investing in an ongoing project, since these costs cannot be recovered. As sunk costs are
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historical costs. These are incurred in the past and not relevant for decision making
Opportunity Costs: These are considered in decision making analysis. In simple terms
opportunity cost means the loss of other alternatives when one alternative is chosen. Costs
should be considered in the differential analysis and explain why and why not: The
differential cost analysis is a useful tool for the management to know the results of any
proposed changes in the level or nature of activity. Under this method, the differential costs
are ascertained for each proposal and compared with the expected changes in revenue
Sunk costs incurred in the past that cannot be changed by future decisions are not
References
saylordotorg.github.io
Differential analysis requires business owners to think about all the potential solutions to a
particular business opportunity in order to determine which one is the most cost- effective
(Berman, n.d.). It is necessary while carrying out differential analysis to ignore cost that
won’t have any effect no matter the solution chosen. According to Lumen (n.d.), differential
revenue is the difference in revenues between two alternatives, while differential cost is the
difference between the amounts of relevant costs for two alternatives. One function of
differential analysis is that owners of business use it to either retain or drop customers. The
following financial data should be included in differential analysis; variable cost, opportunity
cost and sales in revenue. Fixed cost should be excluded.
Specific revenues and costs to be considered to drop or keep a product line and customer;
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One major decision managers are faced with is to determine the selling point of their
products meaning it is no longer cost-effective to continue processing the product before
sale. It is therefore necessary to properly evaluate the costs in order to decide for the
business. In determining whether to keep or drop a product line, alternatives of products
line must be evaluated to know which is more profitable. According to Kristin (n.d.), if a
product is unprofitable, create a product line income statement, and use a contribution
margin income statement to separate variable costs from fixed costs. Both direct fixed costs
and allocated fixed costs should be considered when trying to stop a segment. For Nestle
Company to drop or keep a customer, customer acquisition costs and customer retaining
cost should also be evaluated. Furthermore, a total cost incurred while trying to maintain
customers should be considered.
Opportunity cost is the value of what a company set to lose when choosing between two or
more options (Kennon, 2020). This therefore means the loss one take to make a gain or the
loss of a gain for another gain.
According to Heisinger & Hoyle (n.d.), opportunity cost must be included when performing
differential analysis, while sunk costs on the other hand are not differential costs because
they cannot be changed by future decisions. In addition, Sunk costs cannot be considered in
differential analysis as they were incurred in the past and cannot be reversed.
References
Berman, C. (n.d.). What are some examples of differential analysis in accounting? Retrieved
from https://smallbusiness.chron.com/examples-differential-analysis-accounting-
81985.html
Heisinger, K., & Hoyle, J. B. (n.d.). Accounting for managers. Retrieved from
https://2021books.lardbucket.org/books/accounting-fro-managers/index.html
Indeed Editorial Team, (2021, February 23). Four examples of sunk cost. Retrieved from
https://www.indeed.com/c areer-advice/career-development/sunk-cost-definition-and-
examples
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https://www.thebalance.com/what-is-opportunity-cost-357200
Kristin, (n.d.). Keep or drop: Discontinuing products, departments, and locations. Retrieved
from https://accountinginfocus.com/managerial-accounting-2/short-term-decison-making/
keep-or-drop-discontinuing-products-departments-and-locations/
Krasny, J. (2012, June 25). Every parent should know the scandalous history of infant
formula. Retrieved from https://www.businessinsider.com/personal-finance/nestles-infant-
formula-scandal-2012-6?IR=T
Wunsch, N, .G. (2021, March 26). Nestle group marketing spend 2015-2020. Retrieved from
https://www.statista.com/statistics/685708/nestle-group-marketing-spend/#:~:text=Nestle
%C3%A9%20Group%20marketing%20spend%202015%2D2020&text=In%202020%C%20the
%20Nestl%C3%A9%20Group’s,approximately%2017.4%20billion%20Swiss520francs.
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