Differential

Analysis:
The Key to Decision Making
 Learning • Distinguish between relevant and
Objectives irrelevant costs and revenues in
(alternative-choice) decisions.
• Prepare analyses showing:
• whether to add or drop a segment
• whether to accept or reject a special
order
• whether to make or buy a component
• Rationing A Scarce Resource
• whether to sell or further process a
product
 Types of Cost
Used In Decision
Making
Types of Cost Used In Decision Making

• A future cost that • A future revenue

differs between that differs
any two between any two
alternatives is alternatives is
known as a known as a
differential cost. differential
revenue.
Types of Cost Used In Decision Making

An incremental cost
is an increase in cost
between two An avoidable cost is
alternatives. a cost that can be
eliminated by An opportunity cost
choosing one is the potential
alternative over benefit that is given
another. up when one
alternative is
selected over
another.
• A sunk cost is a cost that has already been
incurred and cannot be changed regardless of
what a manager decides to do.
 Identifying Relevant Costs
• A manager at Purple Co. wants to replace an old machine with a
new one. What costs are relevant?
New machine:
Cost $ 90,000
Annual variable expenses 80,000
Expected life in years 5
Old machine:
Book value 60,000
Disposal value now 15,000
Annual variable expenses 100,000
Remaining life in years 5
Annual fixed expenses, not dep. $ 70,000
 Identifying Relevant Costs
Purchase
Keep Old New
For Five Years Machine Machine Difference
Variable expenses (500,000) (400,000) 100,000
Other fixed expenses (350,000) (350,000) -
Cost - new (90,000) (90,000)
Book value - old (60,000) (60,000) -
Disposal of old machine 15,000 15,000
Total costs $ (910,000) $ (885,000) $ 25,000
Other fixed expenses are the same; book value of the old machine
is a sunk cost. They are not relevant.
Decision Making
Alternative Choices
 Types of Alternative-Choice
Decisions
A B C
Adding or Making or buying Accepting or
dropping a
product or other a component rejecting a special
segments (outsourcing). order.

D F
Rationing of a Sale versus
scarce resource. further
processing.
Adding or Dropping a Segment
•Should we add or drop a
business segment, such as a
product or a store?
•An add-or-drop decision must
be based only on relevant
information.
EXAMPLE:
Purple Company has three product lines. The company is considering
dropping Product 2 because it has been operating at a loss. The following
summarizes the income of the three product lines.
Product 1 Product 2 Product 3 TOTALS

Sales $15,000 $22,000 $37,000 $74,000

Less: Variable Costs 9,000 10,000 19,000 38,000
Contribution Margin $ 6,000 $12,000 $18,000 $36,000
Less: Fixed Costs
Traceable 3,000 10,000 6,000 19,000
Allocated 1,000 3,500 5,000 9,500
Net Income $ 2,000 ($ 1,500) $ 7,000 $ 7,500
 Product 1 Product 2 Product 3

Sales $15,000 $22,000 $37,000

Less: Variable Costs 9,000 10,000 19,000
Contribution Margin $ 6,000 $12,000 $18,000
Less: Fixed Costs
Traceable 3,000 10,000 6,000
Net Income

Product 2 should not be dropped since it

has a positive segment margin.
 With Without
Product 2 Product 2
Sales $74,000 $52,000
Less: Variable Costs 38,000 28,000
Contribution Margin $36,000 $24,000
Less: Fixed Costs
Traceable 19,000 9,000
Allocated 9,500 9,500
Net Income $ 7,500 $ 5,500

If Product 2 is dropped, it will result in lower overall net

income. Hence, the product line should not be dropped.
 Accept or Reject - Special Orders

• There are times when a customer places a

special order for a large volume at lower prices
than that usually charged by the business.
• In this event, the business should properly
decide whether to accept or reject the special
order. The rule is to accept the order if benefits
exceed costs.
 Special Orders - Example
(With Excess Capacity)
• In a month, ABC Company normally produces and sells 8,000
units of its product for $20. Variable manufacturing cost per
unit is $10. Total fixed manufacturing costs (up to the
maximum capacity of 10,000 units) are $38,000. Variable
operating cost is $1 per unit and fixed operating costs total
$10,000.
• A customer placed a special order for 1,500 units for $15 each.
The customer is willing to shoulder the delivery costs; hence
the business will not incur additional variable operating costs.
• Should the company accept or reject the special order?
 Without With
Special Order Special Order

Sales $160,000 $182,500

Less: Variable costs
Var. manufacturing 80,000 95,000
Yes. The selling
Var. operating
price of $15
8,000
exceeds the
8,000
variable
Contributionmanufacturing
margin cost of $10.
$72,000 This
$79,500
will result
Less: in additional income of $7,500
Fixed costs
(1,500
Fixed manufacturing x $5).
38,000 38,000
Fixed operating 10,000 10,000
Operating Income $24,000 $31,500
 Special Orders - Example
(Without Excess Capacity)

• Assume that the company normally manufactures

and sells 9,000 units instead of 8,000. Should the
company accept the special order?
 Without With
Special Order Special Order

Sales $160,000 $192,500

Less: Variable costs
Var. manufacturing 90,000 100,000
Var. operating 9,000 8,500
Contribution margin $81,000 $84,000
Less: Fixed costs
Fixed manufacturing 38,000 38,000
Fixed operating 10,000 10,000
Operating Income $33,000 $36,000
• Contribution margin is equal to sales (at $20) minus variable
costs ($10 variable manufacturing plus $1 variable operating).
• Lost contribution margin = ($20 - $11) x 500 units = $4,500
• The lost contribution margin is allocated over the items sold
through the special order.
• Lost contribution margin per unit = $4,500 / 1,500 units =
$3
• Should the company accept the offer?
• The answer is still yes since the selling price ($15) is higher than the
cost ($13, i.e. variable manufacturing cost per unit of $10 plus lost
CM per unit of $3). This will result in additional income of $3,000
(1,500 x $2).
 Make or Buy

Businesses are sometimes faced with a

decision to choose between buying a
product that it uses in its operations
and making such product.
 Make or Buy - Example
Assume that Friends Company manufactures a product which
requires a particular type of valves. The company currently
purchases the valves from a supplier at a price of $5 per
unit. The company can also produce the valves internally. In
the coming year, the company anticipates a need for 10,000
of such valves. If the company produces the valve internally, it
will incur the following costs:
Direct labor = $1/unit
Direct material = $2/unit
Variable overhead = $0.5/unit
 Make or Buy - Example
The manufacturing process for the valves would also require a
purchase of tooling which is typically used within a year. The cost
of such tooling for the 10,000 valves is $20,000.
Based on this information, Friends Company performs the following
analysis:
 Make or Buy - Example

From the table above, it will cost $55,000 to

manufacture 10,000 valves. At the same
time, it only costs $50,000 to buy the valves
from the supplier. Friends Company should
continue buying the valves from the supplier.
 Rationing A Scarce Resource
• If the objective is to maximize the company profit,
a scarce resource is best used to produce and sell
the product generating the highest CM per unit of
the scarce resource.
• This strategy assumes that the company must
ration only one scarce resource.
 Rationing A Scarce Resource Example

• Active Company produces two products and selected data is

shown below.
A B
CM/unit $ 10 $ 12
Std. machine hrs/unit 1 hr. 2 hrs.
• If only10,000 machine hours are available, which product
should Active focus its efforts on?
Rationing A Scarce Resource Example

A B
CM/unit $ 10 $ 12
Std. requirement/unit 1 hr. 2 hrs.
CM/hour $10 $ 6
• Active should focus its attention on product A, if only 10,000 machine
hours are available:
Total CM = 10,000 * $10, if only A is produced
Total CM = 10,000 * $6, if only B is produced
• Should we sell our product at some point before
the final step in its production?

• As a general rule, a product should be further

processed if the incremental revenues from
processing exceed the incremental processing
costs.
ABC Company manufactures three products. In one production batch, the
company incurs $25,000 manufacturing costs up to the split off-point (the point
in the manufacturing process when the products can be separately identified).
The following summarizes the further processing costs beyond the split-off
point and ultimate sales value.

Further Expected
processing sales
costs revenue
Product 1 $72,000 $90,000
Product 2 $12,000 $28,000
Product 3 $2,000 $12,000
The company can sell the products at split-off
point. The expected sales revenues at split-off
point are: Product 1 - $24,000, Product 2 -
$8,000, Product 3 - $7,000.

Which products should be sold at split-off point

and which products should be processed
further?
 Product 1 Product 2 Product 3

Increase in
$66,000 $20,000 $5,000
sales
Increase in
72,000 12,000 2,000
costs
Effect to
($6,000) $8,000 $3,000
profits

Product 1 should be sold at split-off point. The increase in sales revenue

amounting to $66,000 (i.e., from $24,000 to $90,000) is less than the costs to
process the product further ($72,000). Hence, it is better to sell the product
at split-off point than process it further. Product 2 and Product 3 could be
processed further since it will result in incremental profits.
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