DIFFERENTIAL COST ANALYSIS

DECISION MAKING DEFINED

Decision Making

- Choosing from at least two alternative courses of action.

2 Categories

1. Short-term non-routine

a. Accept or Reject a special order or a business proposal

b. Sell or Process further a product line
c. Make or Buy a part, subassembly or product line
d. Continue Operating or Close a business Segment
e. Product combination
f. Utilization of scarce resources
g. Change in profit factors

2. Long-term Capital Budgeting or Capital Investment

THE DECISION MAKING PROCESS

a. Defining the problem

b. Setting of criteria
c. Identifying the alternative courses
d. Determining of possible consequences of the alternatives
e. Evaluating the alternatives
f. Choosing the best alternative and making the decision

QUALITATIVE AND QUANTITATIVE FACTORS

1. Qualitative Factors
- Those that cannot easily and accurately be expressed in terms of money or any other
numerical unit of measure.
2. Quantitative Factors
- Those that can easily be expressed in terms of money or other units of measure.
Example:

A person based in Manila wants to go to Cebu, and is choosing between going there
by plane or by ship. If he boards on a plane, he will spend about P 1,000.00 for the
plane ticket. If he travels by ship, the transportation cost will be about P 500.00
Quantitative Factor: Transportation fare
Qualitative Factor: Risk, Convenience, Comfort of travelling

APPROACHES IN SOLVING DECISION MAKING PROBLEMS

TOTAL APPROACH
- Under this type of analysis, the total revenue and costs are determined for each
alternative and the results are compared to serve as bases for making decisions.

Illustration:
Assume that Dao-il Company, which sells a chemical product called Fallurin, received a
special order for 1,000 liters of Fallurin from a valued customer. Because of the large volume
of this order, the customer is asking for a discount of 40% off the regular selling price of P25
per liter.
Pertinent data about product Fallurin are as follows:

Normal plant capacity 5,000 liter

Present sales volume (regular customer) 3,000 liter
Production costs
Materials 3.00 per liter
Labor 2.00 per liter
Variable FOH 3.00 per liter
Fixed FOH 7,500.00 per month
Variable Selling and Admin 2.00 per liter
Fixed Selling and Admin 11,250.00 per month

It was ascertained that the special order will not require additional selling and
administrative costs and that the same will not affect regular sales.
Dao-il Company wants to make a decision on whether to accept or reject the special order.
Solution:

Reject the Accept the Special

Special Order Order
Sales (3,500x25) 87,500 (3,500x25) + (1,000x15) 102,500
Less: Costs and Expenses
Materials (3,500x3) 10,500 (3,500 + 1,000) x 3 13,500
Labor (3,500x2) 7,000 (4,500 x 2) 9,000
FOH:
Variable (3,500x3) 10,500 (4,500 x 2) 13,500
Fixed 7,500 7,500
Selling and Admin
Variable (3,500x2) 7,000 7,000
Fixed 11,250 11,250
Total Cost and Expenses 53,750 61,750
Income 33,750 40,750

RELEVANT COSTS

Relevant Costs
- Future costs that are expected to be different under each alternative course of action.

2 Basic Characteristics
a. They are expected future costs, AND
b. They are different between decision alternatives

Note the emphasis given to the word “AND”. This implies that a cost may be a future cost,
yet it is considered irrelevant if it will not differ under each alternative course of action.
Likewise, a cost is irrelevant if, though it is different under each alternative yet it is not a
future cost.

To be relevant, a cost item must possess both of the two characteristics.

A historical cost or past cost therefore is automatically considered irrelevant because it is not
a future cost.
In the illustrative example (Dao-il Company), the relevant costs are the incremental costs as
follows:

Materials 3,000
Labor 2,000
VOH 3,000
Total Relevant Cost 8,000

The other cost items – FOH, selling and administrative costs, despite the fact that they will
be incurred in the future, are considered irrelevant because they will not change under each
alternative course of action (accept or reject).

TYPE OF COSTS USED IN DECISION MAKING

1. Relevant Costs
- Relevant costs are expected future costs that differ under decision alternatives.

2. Differential Costs
- Refer to the increase or decrease in total costs between two alternatives.

Differential Costs
Alternative A Alternative B Increase
(Decrease)
Labor 10,000 12,000 2,000
Repairs and Maintenance 7,000 4,000 (3,000)
Others 2,000 4,000 2,000
Total 19,000 20,000 1,000

3. Avoidable Costs
- Avoidable costs are costs that will be saved or those that will not be incurred if a
certain decision is made. For decision making purposes, this type of costs is usually
considered relevant. For example, if a manager decided to discontinue the
production of a certain product line, the costs of materials, labor , and some factory
overhead items will no longer be incurred as a result of this discontinuance will be
considered as avoidable costs.

4. Out-of-pocket Costs
- Out-of-pocket costs are costs that require current or near future cash outlays or
incurring of liability for a decision at hand. As an example, the cost involved in
buying a new machine is considered as out-of-pocket cost.
 5. Postponable Costs
- Postponable costs are costs that may be deferred or shifted to a future date or period
of time without adversely affecting current operations. For instance the cost involved
in repainting a building is considered postponable cost if the management can decide
to defer the repainting job to a future date. Postponable costs are not avoidable costs.

6. Opportunity Costs
- Opportunity costs refer to the income or benefit sacrificed or foregone when an
alternative is chosen.
- Opportunity costs are not found in the financial accounting records. However, for
decision making purposes, these costs are usually considered relevant.

7. Imputed Costs
- Imputed costs are assumed or hypothetical costs representing the cost or value of a
resource that is utilized for a specific purpose. Examples of this type include rental
value of company’s own assets used in the firm’s business operations, the interest
payments on capital invested by the owners of the firm, and the salary of a
proprietor who spends time in running his own firm.
- Considered relevant in evaluating alternative choice decisions.

8. Sunk Costs
- Sunk costs refer to the non-recoverable costs incurred in the past. They are
considered irrelevant for decision making purposes. Example would be the book
value of old equipment which was purchased by the company in the past.

9. Joint Costs
- Joint costs are usually encountered in the “process further or sell-as-is” problems.
They involve the costs incurred in simultaneously processing or manufacturing two
or more products which are difficult to identify individually as separate types of
products until a certain processing stage known as the point of separation or split-off
point. Joint costs are usually irrelevant in making decisions on whether to sell the
product at the split-off point or sell it later after further processing.

DECISIONS INVOLVING ALTERNATIVE CHOICES

1. MAKE OR BUY
Make or buy decisions involve choosing between producing an item or buying it
from outside suppliers. It usually involves comparing the net relevant manufacturing
costs with the cost of buying the item.
 Example 1:
Let as assume that Lingkod Company, a manufacturer of furniture sets, is
considering purchasing the seat cushions needed for its chairs. The expected
purchase price of these seat cushions is P50 per unit.
Lingkod has been making its own seat cushions since it started operating. If it would
continue to produce these cushions, the company expects to incur the following
costs:

Raw materials 13
Direct labor 15
VOH 5
FOH (based on the average production 20
requirement of 10,000 units)
TOTAL 53

Solution:
TOTAL APPROACH

Make Buy
DM (13 x 10,000) 130,000 Purchase Price 50
DL (15 x 10,000) 150,000 No. of Units 10,000
VOH (5 x 10,000) 50,000
Total Variable Mfg 330,000
Total Purchase Cost 500,000
Cost
Fixed FOH 200,000 Fixed FOH 200,000
TOTAL COST 530,000 TOTAL COST 700,000

Net advantage of making the seat cushions : (530,000 – 700,000) 170,000

DIFFERENTIAL COST ANALYSIS

Purchase Price 50
Less: Relevant Mfg Costs per unit
DM 13
DL 15
VOH 5 33
Difference 17
x No. of Units 10,000
Net advantage of making the seat cushions 170,000
Example 2:
Using the same data as in Example 1 for Lingkod Company, assume that 40% of the
FOH could be eliminated if the company would discontinue the manufacture of seat
cushions. Should the company make or buy the items?

Solution:
Purchase Price 50
Less: Relevant Mfg Costs per unit
DM 13
DL 15
VOH 5
FOH (40% of P20) 8 41
Difference 9
x No. of Units 10,000
Net advantage of making the seat cushions 90,000

Example 3:
Using the same data as in Example 1 for Lingkod Company, assume that materials
and labor costs are expected to increase by 20% next period. FOH costs will remain
the same, except that 40% of the fixed overhead will be eliminated in case the
company decides to buy the seat cushions from other suppliers. Moreover, the
facilities presently being used in the manufacture of seat cushions can be utilized to
manufacture another part of the main product in case the facilities become vacant
when the company decides to stop producing the seat cushions. This alternative use
of resources would result into cost savings of P100,000 for Lingkod Company.
Assume further that the company’s requirement for seat cushions is expected to
increase by 4,000 units next period.

Solution:

No. of units: 10,000 + 4,000 units = 14,000 units

Materials: 13 x 120% = 15.60
Labor: 15 x 120% = 18.00
 Relevant Mfg Costs:
Materials (15.60 x 14,000) 218,000
Labor (18 x 14,000) 252,000
VOH (5 x 14,000) 70,000
FOH (200,000 x 40%) 80,000 620,400
Less net purchase costs:
Purchase cost (50 x 14,000) 700,000
Less: Savings from alternative
Use of facilities 100,000 600,000
Net advantage of buying the seat cushions 20,400

2. ACCEPT OR REJECT A SPECIAL ORDER

Special orders or one-time orders oftentimes possess different characteristics as
compared to with the recurring orders from regular customers. Usually they involve
a larger volume and a discounted or lower sales price. Orders like this should be
evaluated considering the costs relevant to the situation, availability of productive
capacity and the goals of the company.

Example 1:
Assume that Grace Company presently produces and sells 20,000 units of Product G
which represents only 80% of its normal capacity of 25,000 units. Its regular selling
price is P50 per unit and its manufacturing, selling and administrative costs are as
follows:

Materials 10
Labor 12
VOH 8
FOH (60,000/20,000) 3
VSAE 7
FxSAE (40,000/20,000) 2
Total Unit Cost 42
Grace Company received an order from a provincial distributor for 3,000 units. The
customer asks for a special discount of 30%. It is expected that the company will
incur no additional selling and administrative costs.

Solution:
Special selling price (50 x 70%) 35
Less: relevant costs
DM 10
DL 12
VOH 8 30
Marginal Profit 5
x No, of Units ordered 3,000
Incremental profit from accepting special order 15,000

Example 2:
Kapol Company’s normal capacity is 60,000 units. Since the past few months, it has
utilized only half of this capacity. For last month, the result of its operation is
summarized in the following statement:

Sales (30,000 units) 1,500,000

VC 600,000
CM 900,000
FC 500,000
Profit 400,000

Of the variable and fixed costs shown on the statement, ¾ are manufacturing costs;
the balance represents the selling and administrative costs.
This month, a customer submitted a proposal to buy 35,000 units of Kapol
Company’s product at P25 per unit. The only selling cost to be incurred for this order
is 4.00 per unit representing freight charges that will be shouldered by Kapol. If this
special order proves to be acceptable, Kapol is willing to reduce sales to regular
customers so as not to exceed its normal capacity.
Should the order be accepted?

Solution:
SP (1,500,000/30,000) 50 per unit
VC (600,000/30,000) 20 per unit
CM 30 per unit
VOH (3/4 of 20) 15

Special selling price 25

Less: relevant cost per unit
VOH 15
Selling 4 19
CM 6
x No. of Units 35,000
Total CM special order 210,000
Less: CM to be lost by reducing sales
To regular customers (5,000 x 30) 150,000
Incremental profit from the special order 60,000
 3. CONTINUE OR DISCONTINUE OPERATING A BUSINESS SEGMENT
This type of business decision problem is sometimes encountered by some
businesses engaged in producing and/or selling multiple products, or by some
business establishments which are composed of different profit centers. One or more
products or profit centers may show losses or unsatisfactory result of operation, in
which case, management would have to decide whether to continue or discontinue
producing/selling the products or operating the profit center or business segment
concerned.

In analyzing this alternative choice problem, the decision maker has to compare the
revenue or sales generated by the product or business segment under consideration
with their direct avoidable costs.

Example 1: Unprofitable Product

Beth Neri Enterprises sells three products, Skinny, Bony, and Thinny. Bethh, the
proprietor, is concerned about the losses incurred by Thinny, and is considering to
discontinue its production and sales.

Sales and costs data about Beth Neri’s three products are as follows:

Skinny Bony Thinny Total

Sales price per unit 5 7 9 21
VC per unit 2 3 7 12
CM per unit 3 4 2 9
FC per unit 1 2 3 6
Profit (Loss) 2 2 (1) 3
Fixed costs are allocated among the three products based on the floor area they
occupy.

Beth is thinking that if she would eliminate Thinny, its loss of P1 per unit would
likewise be eliminated thereby increasing her total profit per unit from P3 to 4 (2+2).

Is Beth’s analysis correct?

Solution:

Continue Discontinue
Sales Price 9 -
VC 7 -
CM 2 -
FC 3 3
Profit (loss) (1) (3)
 Example 2: Unprofitable Business Segment

Rose Descaya operates a chain of bookstore with branches in Manila, Quezon City,
and Makati. A summary of operating results of the three branches during a typical
month is shown below:

Manila Makati QC Total

Sales 300,000 400,000 500,000 1,200,000
VC 120,000 160,000 200,000 480,000
Direct Fx Cost 50,000 140,000 70,000 260,000
Allocated home office cost 90,000 120,000 140,000 350,000
Total Cost and Expenses 260,000 420,000 410,000 1,090,000
Operating Profit (Loss) 40,000 (20,000) 90,000 110,000

Like in the previous months, Rose observed that the Makati Branch operated at a
loss. Due to this, Rose is considering to close the Makati Branch, hoping that the loss
would be eliminated. She disclosed her plan to her accountant who in turn informed
her that if she would push through with her plan, Makati’s sales, variable cost, direct
fixed cost would all be eliminated. However, total home office costs would not
change; the amount allocated to Makati would just be absorbed by the other
branches.

Should Rose continue operating the Makati Branch despite its operating loss?

Solution:

Continue Discontinue
Sales 400,000 -
VC 160,000 -
Direct Fx Cost 140,000 -
Allocated home office cost 120,000 120,000
Profi (loss) (20,000) (120,000)