BM1915

DIFFERENTIAL COST ANALYSIS

Decision-Making Process
Making decisions is an important management function. However, management’s decision-making process
does not always follow the same pattern because decisions vary significantly in their scope, urgency, and
importance. It is possible, though, to identify some steps that management frequently uses in the process.

Steps in the Decision-Making Process (Payongayong, 2016)

1. Clarify the decision problem.
The decision problem must be clear so that the decision maker can solve it. For example, if a company
receives a special order for its product at a price below the usual price, the decision problem is to accept
or reject the order. However, the decision problem is seldom so clear and unambiguous. Perhaps the
demand for a company’s most popular product is declining. What exactly is causing this problem?
Increasing competition? Declining quality control? A new alternative product on the market? Before a
decision can be made, the problem needs to be clarified and defined in more specific terms. Considerable
managerial skill is required to define a decision problem in terms that can be addressed effectively (Hilton
& Platt, 2017).

2. Specify the decision criterion.

Once a decision problem has been clarified, the manager should specify the criterion upon which a
decision will be made. Is the objective to maximize profit, increase market share, minimize cost, or
improve public service? Sometimes the objectives are in conflict, as in a decision problem where
production cost is to be minimized but product quality must be maintained. In such cases, an objective is
specified as the decision criterion—for example, cost minimization. In the problem to accept or reject, the
criterion to be set is profit. As long as the activity could give profit, the manager most likely would accept
the offer, though qualitative factors must also be considered (Payongayong, 2016).

3. Identify the alternatives.

A decision involves selecting between two (2) or more alternatives. If a machine breaks down, what will be
the alternative courses of action? The machine can be repaired or replaced, or a replacement can be
leased. But perhaps repair will turn out to be more costly than replacement. Determining the possible
alternatives is a critical step in the decision process.

4. Develop a decision model.

A decision model is a simplified representation of the choice problem. When developing a decision model,
the unnecessary details are irrelevant, and the most important elements of the problem are highlighted.
Thus, the decision model brings together the decision problem, the criterion, and the alternatives.

5. Make decisions
Once the decision model is formulated and the pertinent data are collected, the appropriate manager
makes a decision. In this step, the manager compares the alternatives by looking at the advantages and
disadvantages. After implementing a decision, the results of the decision are evaluated to improve future
decisions.

Differential Cost Analysis

Differential Cost Analysis is a decision-making technique in which the evaluation is confined only to those
factors that are different or unique among possible alternatives. It usually involves four (4) steps:
1. Compute all costs associated with each alternative.
2. Ignore sunk costs.
3. Ignore costs that remain largely constant among the alternatives.
4. Select the alternative offering the best cost-benefit scenario.
It is also called incremental analysis or relevant costing.

06 Handout 1 *Property of STI

student.feedback@sti.edu Page 1 of 9
Definition of Terms
 Differential Cost – It is the difference in a cost item under two (2) decision alternatives. The
computation of differential costs is a convenient way of summarizing the relative advantage of one
alternative over the other.
 Incremental cost – It is the additional cost of producing or selling the product or service under
consideration at a certain quantity of output of goods or services rendered.
 Incremental revenue – It is the additional revenue resulting from the sale of goods or services.
 Relevant cost – Relevant costs and benefits satisfy these two (2) criteria: they affect the future and
they differ between alternatives.
 Sunk costs – These are costs that have already been incurred. They do not affect any future cost
and cannot be changed by any current or future action. Sunk costs are irrelevant to decisions.
 Opportunity cost – It is the potential benefit given up when the choice of one action precludes a
different action.
 Avoidable cost – It is a cost that will not be incurred if an activity is suspended.
The terms incremental cost and avoidable cost are often used to describe differential costs (Garrison,
Noreen, & Brewer, 2018).
 An incremental cost is an increase in cost between two (2) alternatives. For example, if you are
choosing between buying the standard model or the deluxe model of your favorite car, the costs of the
upgrades contained in the deluxe model are incremental costs.
 An avoidable cost is a cost that can be eliminated by choosing one alternative over another. For
example, you have decided to watch a movie tonight; however, you are trying to choose between two
(2) alternatives—going to the cinema or renting a movie. The cost of the ticket to get into the cinema
is an avoidable cost. It could be avoided by renting a movie. Similarly, the movie rental fee is an
avoidable cost that could be avoided by going to the movie theater.
Several types of decisions involve differential cost analysis. The most common ones are to decide whether to
do the following:
1. Accept or reject an order at a special price 5. Sell as is or process them further
2. Make or buy component parts or finished 6. Profit maximization by utilizing scarce
products resources
3. Eliminate or continue a product line 7. Retain or replace equipment
4. Shutdown or continue operations

A. Accept or reject an order at a special price

Sometimes a company may have an opportunity to obtain additional business if it is willing to accept an
order to a special customer for a lower price than the regular level. In making this decision, two (2) points
should be emphasized:
1. It is assumed that sales of the product in other markets would not be affected by this special
order, i.e., the company has excess capacity. If other sales will be lost, then the company would
have to consider the lost sales in making the decision.
2. If the company were operating at full capacity, the special order would likely be rejected because
if the offer is accepted, the income of the company will decrease. This is because the offer is
accepted at a lower sales price.

ILLUSTRATION:
Marvel 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 201A are given below:
Direct material P12
Direct labor 10
Fixed manufacturing overhead 8
Variable manufacturing overhead 4
Variable distribution costs 4
Fixed distribution costs 2
 Marvel has received an offer from a potential customer to purchase 50,000 ball bearings at a price of P37
each. If the offer is accepted, variable distribution costs will increase by P2 per ball bearing for shipping
and insurance. The company has excess capacity to produce the offer.
1. What is the relevant unit cost to this special order?
2. Should Marvel accept the offer? By how much will the profit increase or decrease if the order is
accepted?

SOLUTION:
To make the decision, consider the relevant costs.
1. Relevant cost per unit
Variable manufacturing costs:
Direct materials P12.00
Direct labor 10.00
Variable manufacturing overhead 4.00 P26.00

Variable distribution costs 4.00

Additional cost for special order 2.00 6.00
Relevant cost per unit P32.00

2. Net effect of the special order

Selling price of special order P37.00
Relevant cost per unit 32.00
Contribution margin per unit P5.00
x Units to be sold 50,000
Incremental income P250,000

Given the excess capacity of Marvel, the offer should be accepted because the company will have an
increase in profit of P250,000 even if there is an additional P2 variable distribution cost. The relevant cost
per unit is P32.00, but the selling price is P37.00.

B. Make or Buy
When a manufacturer assembles parts in producing a finished product, management must decide
whether to make or buy the components. The decision to buy parts or services is often called
outsourcing.

ILLUSTRATION:
Ancient One Company has 18,000 hours of excess capacity. It needs 20,000 units of a components used
in its product lines. Each unit is estimated to take one-half machine hour for production. The following
information about the unit cost is available:

Cost to make the parts

Materials P14.00
Labor 18.00
Variable manufacturing overhead 6.00
Fixed manufacturing overhead 14.00
Cost to buy the parts from the supplier P48.00

If Ancient One buys the components rather than producing them, it will save 60% of fixed manufacturing
overhead per unit.
1. What are the relevant costs per unit to make and to buy, respectively?
2. Should Ancient One make or buy the components?
 SOLUTION:
In making the decisions, the manager must consider the cost to make and the cost to buy the component.

1. Relevant costs
Cost to make Cost to buy Difference

Direct materials P14.00

Direct labor 18.00
Variable manufacturing overhead 6.00
Fixed manufacturing overhead
(P14.00 x 60%) 8.40
Cost to buy P48.00
Relevant cost per unit P46.40 P48.00 P1.60
x units 20,000 20,000 20,000
Total P928,000 P960,000 P32,000

2. Ancient One Company is better off making the components because it will save P32,000 if the
company will make the components rather than buying it from an outside supplier.

C. Eliminate or Continue a Product Line

Decisions relating to whether product lines or other departments of a company should be continued or
eliminated are among the most difficult that a manager has to make. In such decisions, many qualitative
and quantitative factors must be considered. Ultimately, any final decision to eliminate a product line
centers primarily on its financial impact. To assess this impact, analyze the costs carefully (Garrison,
Noreen, & Brewer, 2018).

Decision rule:
 If the direct contribution margin* is positive – Retain or continue
 If the direct contribution margin is negative – Eliminate
*Direct contribution margin is computed after deducting the avoidable fixed costs to the total contribution margin.

The following information is available for Titan Company. Based on this information, the management is
considering eliminating product line C. They assumed that by operating only product lines A and B, they
would have higher profits. It was also determined that if product line C is discontinued, 60% of the fixed
overhead can be avoided and 50% of the fixed selling and administrative expenses can also be avoided.

Product A Product B Product C

Sales P200,000 P600,000 P400,000
Cost of Goods Sold
Direct Materials 50,000 150,000 160,000
Labor 40,000 80,000 100,000
Variable Overhead 20,000 40,000 30,000
Fixed Overhead 10,000 30,000 70,000
Total 120,000 300,000 360,000
Gross Profit 80,000 300,000 40,000
Selling and Administrative
Variable 24,000 60,000 20,000
Fixed 16,000 80,000 60,000
Total 40,000 140,000 80,000
Net Income (Loss) P40,000 160,000 (40,000)

Based on the above data, should product line C be continued or eliminated?

 SOLUTION:
Sales P400,000
Variable Costs:
Direct materials 160,000
Direct labor 100,000
Manufacturing overhead 30,000
Selling and Administrative 20,000 310,000
Contribution margin P90,000
Avoidable fixed overhead (60%) 42,000
Avoidable fixed S&E (50%) 30,000 72,000
Direct contribution margin P18,000
Product line C should be continued because its contribution margin (P90,000) is greater than the total
fixed costs to be avoided (P72,000).
Alternative computation is shown below if the unavoidable costs are used:
Unavoidable costs
Fixed overhead (P70,000 x 40%) P28,000
Fixed S&E (P60,000 x 50%) 30,000
Total unavoidable costs P58,000
Net loss 40,000
Net Differential cost P18,000

Notice that the net loss to continue the product C is P40,000. If product C is eliminated, the net loss to
be absorbed by the entire company will increase to P58,000 or a net differential cost of P18,000.
Therefore, the manager should decide that continuing the product line is better than eliminating it.

D. Shutdown or Continue Operations

This situation will be encountered when the management determines that the operation would generate
sales lower than the break-even point, i.e., there is a loss. The company will definitely incur a loss if they
continue to operate, but it will also incur a loss by temporary shutdown or closure. As such, the
management will have to choose the alternative with lesser loss.
Shutdown costs are the cost that will be incurred if the operations are shut down. Shutdown costs include
the following:
1. Reduced or unavoidable fixed costs during the shutdown period
2. Any additional costs incurred if the operations will shut down
3. Any estimated costs to restart operations.
If the company shuts down, the total loss will be equal to the total shutdown costs.
Shutdown savings are the cost that will be saved if the company will shut down rather than continue
operations. These include the following:
Total normal fixed costs if to operate Pxxx
Less: Total shutdown costs xxx
Shutdown savings Pxxx
or
Total avoidable fixed costs Pxxx
Less: Additional cost to shut down xxx
Estimated cost to restart operations xxx
Shutdown savings Pxxx
Shutdown point – It is the level of operations at which a company experiences no benefit for continuing
operations. At this point, there is no economic benefit to continuing production. If the demand is lower than
the shutdown point, shutting down operations is more practical than continuing even if the company
continues to experience losses in other areas, such as fixed costs. If the opposite occurs, continuing the
operations is more practical.
𝑆ℎ𝑢𝑡𝑑𝑜𝑤𝑛 𝑠𝑎𝑣𝑖𝑛𝑔𝑠
𝑆ℎ𝑢𝑡𝑑𝑜𝑤𝑛 𝑝𝑜𝑖𝑛𝑡 = = 𝑥𝑥𝑥 𝑢𝑛𝑖𝑡𝑠
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

Decision rule:
 If demand > shutdown point – Continue
 If demand < shutdown point – Shutdown
 If demand = shutdown point – Either decision could give the same loss, it depends on the decision
of the manager.

ILLUSTRATION:
Hydra Company is in the fish canning industry. Its regular monthly production from January to October
averages 200 tons of tuna fish that produces 2,000,000 cans of canned tuna, which may be sold for P10
per can in the market. Its annual fixed costs amount to P36,000,000, which are evenly allocated in a
twelve- month period.
During November and December, the supply of tuna fish goes down to an average of 40 tons or 400,000
cans of canned tuna monthly. Management is considering shutting down operations during November and
December on the belief that the company will be saved from greater losses during these months. If
management decides to shut down operations, additional costs of P100,000 monthly will be incurred for
security and insurance of the plant. The company will also spend an additional P120,000 in restarting the
operations in January.
The following data are gathered from the records of Hydra Company:
Direct materials P6.20
Direct labors 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%.
1. Compute the shutdown costs.
2. Compute shutdown savings.
3. Determine the shutdown point.
4. Evaluate the result of continued operations and compare with the shutdown of operations.

SOLUTION:
1. Shutdown costs
Unavoidable fixed costs during the shutdown period
[(P36 million/12) x 2 months x 60%] P3,600,000
Additional costs incurred (100,000 x 2 months) 200,000
Restarting costs 120,000
Total shutdown costs P3,920,000

2. Shutdown savings
Total normal fixed costs if to operate
[(P36 million/12) x 2 months] P6,000,000
Total shutdown costs P3,920,000
Shutdown savings P2,080,000
3. Shutdown point
𝑆ℎ𝑢𝑡𝑑𝑜𝑤𝑛 𝑠𝑎𝑣𝑖𝑛𝑔𝑠
𝑆ℎ𝑢𝑡𝑑𝑜𝑤𝑛 𝑝𝑜𝑖𝑛𝑡 =
𝐶𝑜𝑛𝑡𝑟𝑖𝑏𝑢𝑡𝑖𝑜𝑛 𝑚𝑎𝑟𝑔𝑖𝑛 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

𝑃2,080,000
=
[10.00 − (𝑃6.00 + 𝑃0.10)]

= 533,333 𝑐𝑎𝑛𝑠

4. The company should continue operations because they will incur an additional loss of P1,040,000
if the operations are shut down. Since the demand is 800,000, which is greater than the shutdown
point, it is more practical for the company to continue the operations even if it will still incur a loss.
Result of continued operations
Sales (800,000 x P10) P8,000,000
Variable Costs:
Cost of Goods Sold (800,000 x P6.00) P4,800,000
Selling and Admin. (800,000 x P0.10) 80,000 4,880,000
Contribution Margin (CM) P3,120,000
Fixed Costs P6,000,000
Net Loss from Continued Operations (P2,880,000)
Total Shutdown Costs 3,920,000
Advantage of Continued Operations P1,040,000

E. Sell As Is or Process Further

Some decision problems arise in manufacturing firms because they may produce two (2) or more products
in a joint production process. The point in the production process where the joint products are identifiable
as separate products is called the split-off point. In some cases, both products can be sold at a split-off
point for a certain selling price or can be processed further and sold at a higher price. However, additional
processing costs must be considered.
Examples: A bicycle manufacturer could sell its bicycles to retailers either unassembled or assembled. A
furniture manufacturer could sell its living room sets to furniture stores, either unfinished or finished. A
company should make the sell-or-process-further decision based on differential cost analysis. This is the
basic decision rule: Process further as long as the incremental revenue from the processing is more than
the incremental processing costs (Weygandt et al., 2018).
Decision rule:
 If incremental selling price (increase in sales value) > additional processing costs = Process further
 If incremental selling price < additional processing costs = Sell as is
The total joint costs are not considered because it is a sunk cost.

ILLUSTRATION:
Wakanda Company uses a joint process to produce products A, B, and C. The joint production costs for
201A were P400,000 and were allocated using relative sales value at the split-off point method.
Each product may be sold at its split-off point or processed further. Additional processing costs are entirely
variable.
Additional
Sales Value at Processing Final Sales
Product Split-off Costs Value
A P200,000 P80,000 400,000
B 400,000 100,000 480,000
C 80,000 120,000 160,000
Total P680,000 P300,000 P1,040,000
 1. To maximize profit, which product/s should be sold at a split-off point and be processed further,
respectively?
2. If the alternative were to sell at the split-off point or to process further all the products, which
alternative would be recommended?

SOLUTION:

1. To maximize profit, only A should be processed further while product B and C should be sold at
split-off.
Product A Product B Product C
Final Sales Value P400,000 P480,000 P160,000
Sales Value at Split-off 200,000 400,000 80,000
Increase in Sales Value 200,000 80,000 80,000
Additional Costs 80,000 100,000 120,000
Differential Income P120,000 (P20,000) (P40,000)

2. To process further is a better alternative because the total differential income for all the products
is P60,000.

F. Utilize Scarce Resources

In break-even analysis, the company assumes a certain sales mix, but management must constantly
evaluate its sales mix to determine whether it is as good as it can be. One factor that affects the sales mix
decision is how much of the available resources each product uses.
In a decision problem such as this, the manager should decide which products must be produced more and
which should be produced less to maximize profit even with limited or scarce resources.
1. Determine the contribution margin (CM) per unit of each product.
2. Determine the required number of scarce resources needed to produce and sell each unit of
product.
3. Determine the contribution margin per scarce resource.
4. Rank the products using the CM per scarce resource. The highest is the most profitable.
5. Maximize production of the most profitable considering the demand constraints for the product.

ILLUSTRATION:
Sharp Rocket Company manufactures and sells three (3) product lines with contribution margin per unit and
the required production time as follows:
CM per Machine hour per
unit unit of product
Product A P9.00 3 hours
Product B 12.00 2 hours
Product C 6.00 2 hours
The company has a capacity of 40,000 machine hours a month. The market can absorb P2,000 units of
product A, 12,000 units of B, and 15,000 units of C.
1. What is the most profitable product line based on the contribution margin per machine hour?
2. Compute the maximum contribution margin for the month that will meet the conditions stated.

SOLUTION:
1. Product B is the most profitable product based on the contribution margin per machine hour. After the
products were ranked, the company must first produce the products with the highest CM per machine
hour.
CM per Machine CM per
Ranking
unit hour machine hour
Product A P9.00 3 hours P3.00 2nd
Product B 12.00 2 hours P6.00 1st
Product C 6.00 2 hours P2.00 3rd
 2. Maximum contribution margin
Units of Machine hours (MH CM per
Product x units of product) machine hour Total CM
Product B 12,000 24,000 P6.00 P144,000
Product A 2,000 6,000 P3.00 18,000
Product C 5,000 *10,000 P2.00 20,000
19,000 40,000 P182,000
*40,000 – 24,000 – 6,000 = 10,000

Since there are limited resources to produce all the products, the company must produce the more
profitable products. In this case, all of the 12,000 units of product B and 2,000 units of product A will
be produced. Consequently, only 10,000 machine hours were left to produce product C. In this case,
only 5,000 units were produced, not 15,000.
G. Retain or Replace Equipment
Management often has to decide whether to continue using an asset or to replace it. Sometimes,
decisions regarding whether to replace equipment are clouded by behavioral decision-making errors. For
example, a manager spent P90,000 repairing a machine a month ago, and that same machine breaks
down again today. The manager might be inclined to think that, because the company recently spent a
large amount of money to repair the machine, the machine should now be repaired rather than replaced.
However, the amount spent in the past to repair the machine is irrelevant to the current decision because
it is a sunk cost.
Similarly, suppose a manager spent P1 million to purchase a new machine. Six months later, a new and
significantly more efficient machine comes on the market. The manager might be inclined to think that the
company should not buy the new machine because of the recent purchase. The manager might fear that
buying a different machine so quickly might call into question the value of the previous decision. Again, the
fact that the company recently bought a new machine is not relevant. Instead, the manager should use
incremental or differential cost analysis to determine whether the savings generated by the efficiencies of
the new machine would justify its purchase.

ILLUSTRATION:
Pym Technologies, Inc. is considering replacing its old machine with a book value of P75,000 and still has
a remaining useful life of five (5) years. The old machine will be replaced with a new one that will cost
P250,000, with five-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 operations. The old machine will have no disposal value after five (5)
years but can be disposed now at P20,000. Ignoring the time value of money and income taxes,
determine the differential cost.
SOLUTION:
Cost of the new machine P250,000
Add: Operating costs (P90,000 x 40% x 5) 180,000
Less: Disposal value of old machine (20,000)
Reconditioning cost of old machine (10,000)
Total relevant cost to replace P400,000
Total relevant cost to retain (P90,000 x 5) 450,000
Differential cost P50,000
The book value of the old machine is a sunk cost and is not relevant to the decision. Reconditioning costs
of the old machine is an avoidable cost and is relevant to the decision if the decision is to replace the old
machine.
Decision: The manager should decide to replace the old with new equipment since the total relevant cost
to replace is lower than the total relevant costs if the old machine is retained.
References:
Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial Accounting. New York: McGraw-Hill Education.
Hilton, R. W., & Platt, D. E. (2017). Managerial Accounting: Creating Value in a Dynamic Business Environment. New York: McGraw-Hill Education.
Payongayong, L. S. (2016). Management Services Part 2. Manila: Polytechnic University of the Philippines.
Weygandt, J. J., Kimmel, P. D., Kieso, D. E., & Aly, I. M. (2018). Managerial Accounting: Tools for Business Decision-Making. Canada: John Wiley & Sons, Inc.