DEFINITIONS:

• Differential Cost Analysis – is the study of relevant costs that are associated with a decision
among possible courses of actions so that the most appropriate alternative may be selected.
• Differential (Incremental) Costs – is the difference in cost between two alternatives.
SCHOOL OF ACCOUNTANCY, BUSINESS and HOSPITALITY • Relevant Costs – are expected future costs that will differ among alternatives.
Accountancy Department • Opportunity costs – are the foregone benefits from an alternative not selected. Opportunity costs
SHORT TERM 2021 do not require an actual cash outlay.
A.Y. 2020-2021 • Avoidable costs – are costs that will not be incurred if an activity is suspended.
• Marginal costs – are costs of producing or selling one more unit of product and added to total
MGMT 1033 - Strategic Cost Management costs.
• Sunk costs – are historical (past) costs incurred as a result of past decisions and not relevant in
current decision making.
Week 5 – Differential Cost Analysis (Relevant Costing) • Out-of-pocket costs – are costs required for immediate or near future cash outlays.
• Imputed costs – are hypothetical costs representing the cost or value of a resource measured by
Learning Outcomes: At the end of this module, you are expected to: its value. Imputed costs do not involve cash outlay and are not recorded in the books. However, in
1. Discuss the concept of differential cost analysis and its relevance as a decision problems, imputed costs are relevant and important.
cost management tool;
2. Elaborate the concepts used in most differential cost decisions;
3. Explain the qualitative factors in making differential cost decisions; CONCEPTS USED IN MOST DIFFERENTIAL COST DECISIONS
4. Apply differential cost analysis on the following management
decisions: 1. The only relevant costs or revenues are those expected future costs and revenues that differ
a. Special Orders among alternatives.
b. Sell or Process Further 2. All costs incurred in the past (sunk cost) are irrelevant, unless they have future tax effects.
c. Make of Buy 3. Opportunity costs, the expected income obtainable from an alternative, must be considered.
d. Scrap or Rework
e. Eliminating a Division or Product Line
f. Shutting Down Operations RELEVANT ITEMS IN DECISION MAKING
g. Product Mix or Combinations 1. They are expected future costs or revenues: and
2. They differ among alternatives.
LEARNING CONTENT:
QUALITATIVE FACTORS THAT MUST BE CONSIDERED IN DECISION MAKING:
Introduction:
1. Effect on present and future customers.
When making management decisions, the quantitative aspect of certain issue is given reasonable emphasis. 2. Effect on employee morale, schedule and other internal elements.
It is based on a fundamental premise that the benefits derived in pursuing an option exceed the costs 3. Relationship with suppliers.
associated to it. Hence, when there are alternatives available for consideration, the manager must be able to
justify which among alternatives would best benefit, not only a certain aspect of the operation, but to the
business as a whole. The decision should also encompass qualitative areas of the business that could have MANAGEMENT DECISIONS INVOLVE:
drastic and long-term adverse effect.
1. Special Orders – accepting or refusing certain orders.
The role of differential cost analysis emphasizes those areas where costs vary for each alternative or option. 2. Sell or Process Further – determining whether to sell or process further.
In considering the better or best option, as a rule, choose the option that gives the LEAST COST or 3. Make of Buy – producing internally or buy component parts outside.
HIGHEST MARGIN. 4. Scrap or Rework – determining whether to sell as scrap (junk) or to rework (modify).
5. Eliminating a Division or Product Line – determining whether to discontinue a losing product
line or division.
6. Shutting Down Operations – determining whether to continue or shut down operations.
7. Product Mix or Combinations – to determine which products should be given priority in
production
CRITERION FOR SHORT-TERM DECISIONS ILLUSTRATION 2 – “SELL OR PROCESS”
1. The only revenues and costs that are relevant in making decisions are the expected future Jilly Boy Company uses a joint process to produce Products A, B, and C. Joint production costs for 2021
revenues and costs that differ among available (alternative) choices. These are called Differential were P200,000 and are allocated using the relative-sales value at split-off method.
Revenues and Costs also termed as Incremental Revenues and Costs.
Each product may be sold at its split-off point or processed further. Additional processing costs are
2. Revenues and costs that have already been earned or incurred (past revenues and costs) are
entirely variable. Relevant data are given below:
irrelevant in making decisions. They are only used to aid in predicting future revenues and costs.
3. Opportunity costs (benefit lost) by choosing one alternative as opposed to another are relevant Product Sales Value Additional Final Sales
costs. at Split-Off Processing Costs Value
A P100,000 P 40,000 P200,000
B 200,000 50,000 240,000
ILLUSTRATION 1 – “SPECIAL ORDER” C 40,000 60,000 80,000
P340,000 P150,000 P520,000
Jilly Boy Company produces a ball bearing used in bantam cars. Each ball bearing sells for P45
and the company sells approximately 500,000 ball bearings each year. Unit cost data for 2021 given
below: Required:

Fixed Variable Fixed Variable 1. To maximize profit, which product or products should be sold at split-off point and which product
Direct material - P12 Factory overhead P8 P4 or products should be processed further?
Direct labor - 10 Distribution costs 2 4 2. If the alternatives were either to sell all at split-off point or process further all the products, which
alternative would you recommend?

Jilly Boy received an offer from a foreign buyer to purchase 50,000 ball bearings. Domestic sales SOLUTION:
would not be affected by this transaction. The offer price is P37. If the offer is accepted, variable
To Process Further: Product A Product B Product C
distribution costs will increase P2 per ball bearing for shipping, insurance, and import duties. The
Revenues: P200,000 P240,000 P 80,000
company has idle capacity to produce the offer. Additional Costs: 40,000 50,000 60,000
Required: Net Revenues P160,000 P190,000 P 20,000
To Sell Outright: 100,000 200,000 40,000
1. What is the relevant unit cost to this special order? Differential Income P 60,000 (P10,000) (P20,000)
2. Determine the net effect of the special order.
Solution: 1. To maximize profit, only Product A should be processed while Products B and C should be sold
at split-off point.
1.
2. To process further is a better alternative because the total differential income for Products A, B,
Variable Production Costs: and C (P60,000-P10,000-P20,000) is P30,000.
Direct materials P12
Direct labor 10
Factory overhead __4 P 26 ILLUSTRATION 3 – “MAKE OR BUY”
Variable Distribution Costs:
Regular sales P4 Jilly Boy Company has 15,000 hours of idle capacity. They need 20,000 units of a component part used in
Special order 2 __6 its product lines. It is estimated that each unit will take one-half machine hour for production. The
Relevant Unit Cost P 32 following information is available:
Cost to make the parts:
2.
Materials P14
Differential Direct labor 18
Incremental Revenues (50,000 x P37) P 1,850,000 Factory overhead (75% of direct labor cost per unit)
Incremental Costs (50,000 x P32) 1,600,000 Variable factory overhead (40% of factory overhead per unit)
Increase in Operating Income P 250,000 Cost to buy the parts per unit from the supplier P45
If Jilly Boy Company buys the parts rather than producing them, it will save 60% of fixed overhead cost SOLUTION:
per unit.
Relevant Revenues: Scrap Modify Differential
Required: Sales Price P 5,000 P25,000 P20,000
Relevant Costs:
1. Determine the relevant unit costs. Materials (P10,000) (10,000)
2. Determine the relevant total costs and differential costs. Labor ( 3,000) ( 3,000)
3. Should Jilly Boy Company manufacture the parts, or should it but them from the outside Overhead ( 1,200) ( 1,200)
supplier? Net Revenues P 5,000 P10,800 P 5,800
SOLUTION:
1. To modify is better because it gives a Differential Income of P5,800.

Make Buy
Materials P14.00 ILLUTRATION 5 – “ELIMINATE OR CONTINUE A PRODUCT LINE”
Direct labor 18.00
Variable factory overhead (P18 x 75% x 40%) 5.40 The following data were taken from the Jilly Boy Company. Based on these data, the management of Jilly
Fixed factory overhead (P18 x 75% - P5.40) x 60% 4.86 Boy is considering eliminating product line B. They assumed that by operating only product line A and C,
Cost to buy P 45 the company would have higher profits.
Relevant unit costs P42.26 P45.00
Product A Product B Product C
Sales P 100,000 P200,000 P300,000
2. Cost of Sales:
Materials P 25,000 P 80,000 P 75,000
Relevant Costs: Labor 20,000 50,000 40,000
To Buy: (20,000 x P45.00) P 900,000 Variable overhead 10,000 15,000 20,000
To Make: (20,000 x 42.26) 845,200 Fixed overhead 5,000 35,000 15,000
Differential Savings to Make the Parts P 54,800 Total P 60,000 P 180,000 P 150,000
Gross Margin P 40,000 P 20,000 P 150,000
3. Selling and Administrative:
Variable P 12,000 P 10,000 P 30,000
Jilly Boy Company is better of making the needed parts because it will save the company Fixed 8,000 30,000 40,000
P54,800. Total P 20,000 P 40,000 P 70,000
Net Income (Loss) P 20,000 P (20,000) P 80,000

It was determined that if product line B is discontinued, 60% o the fixed overhead can be avoided and
ILLUSTRATION 4 – “SCRAP OR REWORK” 50% of fixed selling and administrative expenses can also be avoided.

Jilly Boy Company has 5,000 obsolete truck parts that are carried in their inventory at a cost of P50,000.
The company is faces with a decision whether to scrap the parts or modify them. If the parts were junked, Required: Based on the above data, should product line B be eliminated? Present your solution.
it would realize only 10% of its cost. Should the company modify the parts, it will spent P10,000 for
materials, P3,000 for direct labor, and overhead equal to 40% of direct labor. The new parts will sell for
P25,000 in the market.

Required: Should Jilly Boy Company modify or scrap the parts? Determine the relevant and differential
costs.
SOLUTION: Required:
Product Line B: 1. Compute the shutdown costs.
2. Determine the shutdown point.
Sales P 200,000 3. Evaluate the result of continued operations and compare with shutdown of operations.
Variable Costs:
Materials P 80,000
Labor 50,000
Overhead 15,000 SOLUTION:
Selling and administrative 10,000 155,000 1. Computation of Shutdown Costs:
Contribution Margin P 45,000 Unavoidable Fixed Costs: (P18,000,000/12) x 2 months x 60% P1,800,000
Fixed Costs avoided if eliminated: Additional Shutdown Costs:
Overhead (60%) P 21,000 Security and Insurance (P50,000 x 2 months) 100,000
Selling and administrative 15,000 36,000 Re-starting Costs 60,000
Excess of Contribution Margin P 9,000 Total Shutdown Costs P1,960,000

Product line B should be continued because its contribution margin (P45,000) is greater than the 2. Computation of Shutdown Point:
costs to be avoided from fixed overhead (60% x P35,000) and fixed selling and administrative
(60% x P30,000) totalling P36,000. Total Fixed Costs – Shutdown Costs *P3,000,000 – P1,960,000
Shutdown Point = =
Contribution Margin per Can P10.00 – (P6.00 + P0.10)

*(P18,000,000/12) x 2 = P3,000,000
ILLUSTRATION 6 – “SHUTDOWN OR CONTINUE OPERATIONS”
The Jilly Boy Company is in the fish canning industry. Its regular monthly production from January to Shutdown Point = 266,667 Cans
October averages 100 tons of tuna fish that will produce 1,000,000 cans of canned tuna that can be sold at
P10 per can in the market. Its annual fixed costs amount to P18,000,000 which are evenly allocated on a 3. Result of Continued Operations:
twelve-month period. Sales (400,000 x P10) P4,000,000
Variable Costs:
During the months of November and December, the supply of tuna fish goes down to average of 20 tons Production Costs: (400,000 x P6.00) P2,400,000
monthly or 200,000 cans of canned tuna monthly. Selling and Administrative (400,000 x P0.10) 40,000 2,440,000
Management is considering to shutdown operations during the months of November and December on the Contribution Margin P1,560,000
Fixed Costs (3,000,000)
belief that the company will be saved from greater losses during these months.
Net loss from operations (P1,440,000)
If management decides to shutdown operations, additional costs of P50,000 monthly will be incurred for Total Shutdown Costs 1,960,000
security and insurance of the plant. The company will also spend additional P60,000 in re-starting
operations in January. Advantage of Continued Operations P 520,000

The following data are gathered from the records of Jilly Boy Company;

Raw materials and ingredients P 5.20

Direct labor 0.55
Variable overhead 0.25
Total variable cost per can P6.00

Variable selling and administrative expenses averages P0.10 per can. It is assumed that the market can
absorb all canned tuna produced.
Shutdown operations will reduce fixed costs during November and December by 40%.
ILLUSTRATION 7 – “PRODUCT MIX – SCARCE RESOURCES”
Jilly Boy Company manufactures and sells three lines of product with contribution margins per unit as
follows: Product A =P12; Product B = P2; Product C =P5
Each unit of product requires production time as follows: Product A = 3 hours; Product B = 10 minutes;
Product C = 2 hours
The company has plant capacity of 20,000 machine hours a month. The market can absorb 2,000 units of
Product A, 24,000 units of Product B and 15,000 units of Product C.
Required:
1. What is the most profitable product line on the basis of contribution margin per machine hour?
2. Complete the maximum contribution margin for the month that will meet the conditions stated.
ILLUSTRATION 8 – “KEEP OR REPLACE”
The Jilly Boy Company is considering to replace its old machine with a book value of P75,000 and still
have remaining useful life of 5 years. The old machine will be replaced with a new one that will cost
P250,000, will have 5-year useful life and no salvage value.
The annual operating costs of the old machine amount to P90,000 which can be reduced by 60% if a new
machine is acquired. The old machine would require reconditioning that will cost P10,000 if not replaced
which will be incurred before it starts operation. The old machine will have zero disposal value after 5
years, but can be disposed now at P20,000.
Required:
Ignoring the time value of money and income taxes, determine the relevant and differential costs.
(Quantify for five-year period)

SOLUTION:
SOLUTION:
1.
Relevant cost to Replace:
Product CM Per Unit M.T. Per Unit CM per Hour Cost of new machine P250,000
A P12 3 hours P 4.00 Add: Operating Costs: (P90,000 x 40% x 5 years) 180,000 P 430,000
B 2 10 minutes 12.00 Less: Disposal Value of old machine P 20,000
C 5 2 hours 2.50 Reconditioning of old machine 10,000 30,000
Total Relevant Costs to Replace P400,000

Product B is the most profitable product on the basis of contribution margin per machine hour. Relevant Costs to Keep:
Operating Costs of Old Machine (P90,000 x 5) 450,000
2.
Differential Cost P 50,000
Product Units of Product Machine Hours CM Per Hour Total CM
A 2,000 6,000 P 4.00 P 24,000
B 24,000 4,000 12.00 48,000 Note: The book value of the old machine is a sunk cost and is not relevant to the decision.
C **5,000 *10,000 2.50 25,000 Reconditioning costs of the old machine is an avoidable cost and is relevant if the decision is to
Totals 31,000 20,000 P 97,000 replace the old machine. This problem would normally fall under CAPITAL BUDGETING (last
topic for the final term) when time value of money and income taxes are being considered.

*(20,000 – 4,000 – 6,000) = 10,000 hours **(10,000 hours/2) = 5,000 units

END