DIFFERENTIAL ANALYSIS

Making decisions is an important management function. Management’s decision-

making process does not always follow a set pattern because decisions vary
significantly in their scope, urgency and importance. The steps in management’s
decision-making process are:
1. Identify the problem and assign responsibility.
2. Determine and evaluate possible courses of action.
3. Make a decision.
4. Review results of the decision.

Accounting’s contribution to the decision-making process occurs primarily in

Steps 2 and 4. In Step 2, for each possible course of action, relevant revenue and cost
data are provided. These show the expected overall effect on net income. In Step 4,
internal reports are prepared that review the actual impact of the decision, which
reports usually contain financial data of actual revenue and cost (through performance
reports, for example).

Decisions are made in all phases of organizational activities. Decisions may be

strategic, tactical, or operational. Strategic decisions have long-term effects, its focus is
growth and stability, it uses capital budgeting as management accounting tool or
technique and it is concerned of meeting the needs of investors. Tactical decisions are
made regularly, with medium-term effects in the organizational activities and outcome,
its focus is profitability and liquidity, it uses the management accounting tools or
techniques of standard costing, responsibility accounting, budgeting, CVP analysis and
incremental or differential analysis, and it is concerned with customer’s satisfaction.
Operational decisions are made on a daily basis where the judgment call of a supervisor
is at its greatest use.

In making business decisions, management ordinarily considers both financial

and nonfinancial information. Financial information is related to revenues and costs
and their effect on the company’s overall profitability. Nonfinancial information
relates to such factors as the effect of the decision on employees’ turnover, the
environment, or the overall image of the company in the community. Nonfinancial
information can be as important as the financial information in making decisions.

Decisions involve a choice among alternative courses of action. Differential

analysis uses relevant revenues and costs to make decisions. It is the result of
defining a decision rule and quantifying and formatting relevant information.
Differential analysis contrasts choices by comparing incremental contribution margins.
Two commonly used approaches are applicable to all decision types---the incremental
analysis approach and the total analysis approach. The incremental analysis approach
includes only incremental revenues and costs of each choice, while total analysis
approach shows the results for the total entity, including the alternative and then,
excluding the alternative.

The process used to identify the financial data that change under alternative
courses of action is called incremental analysis. When using incremental analysis, in
some cases, both revenues and costs will vary, while in other cases, only revenues or
costs will vary. Incremental profit is the difference between the relevant/incremental
revenues and the relevant/incremental costs of each choice. Relevant revenues and
costs are defined as the current and future values that differ among the choices
considered. In most cases, the term “incremental” is used as a substitute for
“relevant”. In choosing among choices, all past and committed costs (often referred to
as sunk costs) and all costs that remain the same across all choices are irrelevant and
are ignored. Relevant revenues are often assumed to be cash inflows, and relevant
costs are cash outflows. Out-of-pocket costs refer to costs that are cash outflows.
Another relevant factor in making decision is the opportunity cost of using capacity (if
there is any).

Key cost concepts used in incremental analysis:

 Relevant cost - are those costs that differ across alternatives. Relevant costs
have two features --- differential and future-oriented. If a cost differs from
one option to another, that cost is differential which may be incremental (if cost
is increasing) or decremental (if cost is decreasing) in nature. Future costs are
referred to as planned costs, budgeted costs, projected costs, or estimated costs.
Future costs are yet to be incurred in upcoming or future activities.
 Opportunity cost - The lost benefit or the opportunity given up to benefit from
some other course of action.
 Sunk cost - costs that have already been incurred and will not be changed or
avoided by any future decision. Sunk costs are not relevant costs.

“MAKE OR BUY A PRODUCT”

DATA ANALYSIS FORMAT OF THE ‘MAKE’ OR ‘BUY’ DECISION:

‘MAKE’ Costs/Costs to ‘MAKE’:
Materials and direct labor xxx
Variable overhead costs xxx
Avoidable fixed overhead costs xxx
Opportunity costs of additional resources needed _xxx
TOTAL RELEVANT COSTS TO “MAKE” XXXX

‘BUY’ Costs/Costs to ‘BUY’:

Purchase cost xxx
Handling costs xxx
Incremental revenue or earnings from use of
released resources (xxx)
Savings in buying the part/product (xxx)
TOTAL RELEVANT COSTS TO “BUY” XXXX
In deciding to make or buy a part or product, the total relevant costs of each
option should be taken. Whichever option gives a low relevant cost (resulting to a net
advantage or savings compared to the one with a high relevant cost) would be a better
alternative, assuming no other quantitative and qualitative factors are to be considered.

SAMPLE PROBLEM 1:
Sharp Corp. has bids from several suppliers for a control device, a unit used in
several models of its Hibeam Line of lighting features. Sharp made these devices for
the past several years and needs 30,000 units for this year’s production requirements.
Walker Wiring returned the most attractive bid at $3 per unit delivered. Quality control
inspections of purchased units would cost Sharp $3,000. Sharp’s costs for 25,000 units
last year were:
Per Unit Total Costs
Materials $ 1.25 $ 31,250
Direct labor .60 15,000
Variable overhead .50 12,500
Fixed overhead applied 1.00 25,000
Total $ 3.35 $ 83,750
All costs are direct costs, except fixed factory overhead. The only direct and
avoidable fixed factory overhead is $6,000, the cost of leasing specialized equipment
required to make the control device. If the device is purchased, Sharp could return the
specialized equipment, void the lease, and use the space for storage. Renting storage
space would cost $4,000 next year.
Will Sharp make or buy the unit? Why?

SAMPLE PROBLEM 2:
Toblerone Corp. manufactures Part X-24 for use in its production cycle. The cost
per unit for 10,000 units of Part X-24 are as follows:
Direct materials P 6.00
Materials handling costs (20%) 1.20
Direct labor 20.00
Variable overhead 5.00
Fixed overhead 11.00
Total P 43.20
Ferrero Co. has offered to sell Toblerone Corp. 10,000 units of Part X-24 for P40
per unit.
If Toblerone accepts Ferrero’s offer, P4 of the fixed overhead per unit could be
eliminated. The materials handling costs pertain to the cost of receiving and inspecting
incoming materials and other components which are not included in the overhead.
If the Part is outsourced from an outside supplier, one-half of the released
facilities could be used to produce a new product, Citrus, which is expected to generate
a contribution margin of P90,000 per year. Additionally, a saving of P15,000 is
expected if the Parts are purchased outside. The other half of the released facilities
could be rented out for P60,000 per annum.
The outside supplier requires that an equipment be leased to meet the order of
the Company. The equipment rental cost of P80,000 shall be charged to the Company.
What alternative is better, make or buy the Part, and by how much is its
advantage?

SOLUTIONS TO THE SAMPLE PROBLEMS

SHARP:
Costs to MAKE Costs to BUY
Materials ($1.25 x 30,000) $ 37,500
Direct labor ($0.60 x 30,000) 18,000
Variable overhead ($0.50 x 30,000) 15,000
Equipment lease cost/avoidable fixed overhead 6,000 -----
Purchase price ($3 x 30,000) $ 90,000
Quality control costs 3,000
Rent on storage space _______ _(4,000)
TOTAL RELEVANT COSTS $ 76,500 $ 89,000
NET ADVANTAGE/SAVINGS TO “MAKE” $ 12,500

TOBLERONE:
Costs to MAKE Costs to BUY
Direct materials (P6 x 10,000) P 60,000
Direct labor (P20 x 10,000) 200,000
Variable overhead (P5 x 10,000) 50,000
Avoidable fixed overhead (P4 x 10,000) 40,000 -----
Materials handling costs:
To make (P60,000 x 20%) P12,000 -----
To buy (P400,000 x 20%) 80,000 P 68,000
Purchase price (P40 x 10,000) 400,000
Additional savings if the part is bought (15,000)
Rental income from released facilities (60,000)
Contribution margin from a new product, Citrus (90,000)
Rental of equipment if the part is bought ________ __80,000
TOTAL RELEVANT COSTS P 350,000 P 383,000
NET ADVANTAGE/SAVINGS TO “MAKE” P33,000

“ACCEPT OR REJECT A SPECIAL ORDER”

DATA ANALYSIS FORMAT OF THE ‘ACCEPT’ OR ‘REJECT’ DECISION:

Incremental revenue xxx
Incremental costs:
Additional variable costs (xxx)
Additional direct fixed costs (xxx)
INCREMENTAL PROFIT/(DECREMENTAL PROFIT) XXXX

SAMPLE PROBLEM 1:

North Comm’s capacity is 90,000 units of a cellular phone receiver, including

15,000 units made on overtime. North Comm is currently producing and selling 80,000
units per year at $8 per unit. Variable production costs are $3 per unit, and annual
fixed factory overhead costs are $200,000. Variable shipping costs are $0.50 per unit.
All administrative expenses are $120,000 and fixed. The profit calculation is as follows:

Sales (80,000 units x $8) $ 640,000

Less: Factory and shipping costs:
Variable (80,000 units x $3.50) $ 280,000
Fixed overhead 200,000 480,000
Gross profit 160,000
Less: Administrative expenses 120,000
Net Income $ 40,000

A communications company approaches North Comm with an offer to buy

10,000 receivers at $6 each. Sales to that company will not affect North Comm’s
regular sales. The special units would require minor modifications and force more
overtime, adding $0.80 per unit to variable costs. Additional supervision would cost
$3,000. The entire lot would be packed and shipped for $2,000.
Will North Comm accept or reject the special order? Why?
SAMPLE PROBLEM 2:

The manufacturing capacity of NorthWind Corporation’s facilities is 50,000 units

of product a year. A summary of operating results for the year end December 31 of
last year is as follows:
Total Per Unit
Sales (38,000 units) P 3,800,000 P 100.00
Less: Variable costs and expenses 2,090,000 55.00
Contribution margin P 1,710,000 P 45.00
Less: Fixed costs and expenses 900,000
Operating Income P 810,000

A distributor company has offered to buy 12,000 units at P90 per unit during this
year. All of the Corporation’s costs would be at the same levels and rates for this year
as that of last year.
Should NorthWind Corp. accept or reject the special sales order?

Consider the following cases independently:

1. The corporation has no alternative use of the idle capacity.
2. The corporation can rent out the idle capacity for P200,000.
3. The corporation can use the idle capacity to produce a new product that
could give a P600,000 contribution margin.
4. If the special order is accepted, 2,000 units of regular sales are expected to
be lost.
5. Assuming a distributor has ordered 16,000 units and the corporation has to
sacrifice some of its regular customers to accommodate the special order.

SOLUTIONS TO THE SAMPLE PROBLEMS

NORTH COMM:
Incremental sales revenue ($6 x 10,000 units) $ 60,000
Incremental costs:
Incremental variable production costs ($3 x 10,000) (30,000)
Additional variable factory costs-overtime ($0.80 x 10,000) (8,000)
Additional supervision costs (3,000)
Packing and shipping costs __(2,000)
INCREMENTAL PROFIT ON THE SPECIAL ORDER $ 17,000

NORTHWIND:
1. Incremental sales revenue (P90 x 12,000 units) P 1,080,000
Incremental costs-Variable costs & expenses
(P55 x 12,000 units) ___660,000
INCREMENTAL PROFIT TO ACCEPT SPECIAL ORDER P 420,000

2. Incremental profit/contribution margin on the special order

(P90-P55=P35) x 12,000 units P 420,000
Rent income if the facility is rented out-opportunity cost _(200,000)

NET ADVANTAGE OF ACCEPTING the special order P 220,000

3. Incremental CM on the special order P 420,000

Contribution margin on the new product-opportunity cost __(600,000)
 NET ADVANTAGE OF REJECTING the special order (P180,000)

4. Incremental CM on the special order P 420,000

Contribution margin lost from regular sales
(P100-P55=P45) x 2,000 units-opportunity cost __(90,000)
NET ADVANTAGE OF ACCEPTING the special order P 330,000

5. Incremental CM on the special order (P90-P55=P35 x 16,000 units) P 560,000

Contribution margin lost from regular sales sacrificed
(P100-P55=P45) x (16,000-12,000=4,000 units)-opportunity cost (180,000)
NET ADVANTAGE OF ACCEPTING the special order P 380,000

SAMPLE PROBLEMS:

 The Marikina Shoe Company (MSC) manufactures various types of shoes for sports
and recreational use. Several types of shoes require a built-in air pump. Presently,
the company makes all the air pumps it requires for production. However,
management is evaluating an offer from Bulacan Air Supply (BAS) to provide air
pumps at a cost of P60 each. Marikina Shoe Company management has estimated
that the variable production costs of the air pump are P50 per unit. The firm also
estimates that it could avoid P400,000 per year in fixed costs if it will purchase
rather than produce the air pumps.

Required:
1. If MSC requires 50,000 pumps per year, should it make or buy the pumps from
BAS?
2. If MSC requires 35,000 pumps per year, should it make or buy the air pumps?
3. Assuming all other factors are equal, at what level of production would the
company be indifferent between making and buying the pumps?
4. If MSC wants to save P4 per air pump, how much should it be willing to pay on
external supplier to buy each pump for 40,000 units?

 Dasma Company produces organic fertilizer which is retailed through farm supply
companies. Presently, the company uses 85% of its maximum capacity of 2,000
tons a year. Under its present capacity, the company has the following costs
structure of producing a ton of fertilizer:
Direct materials P 1,600
Direct labor 2,400
Variable overhead 2,100
Fixed overhead _1,000
TOTAL P 7,100

The average sales price of the fertilizer is P10,000 per ton. The firm has been
approached by a Malaysian company about supplying 250 tons of fertilizer next year
at a price of P6,800 per ton, FOB Dasma Company’s plant. No production
modifications would be necessary to fulfil the order from the Malaysian company.

Required:
1. What are the relevant costs to the decision to accept this order?
2. What would be the effect on pretax income if this order is accepted?
 3. Determine the opportunity cost if Dasma Company rejects the special order.

“SELL OR PROCESS FURTHER A PRODUCT”

DATA ANALYSIS FORMAT OF THE ‘SELL’ OR ‘PROCESS FURTHER’

DECISION:
Incremental revenue xxx
Incremental costs (xxx)
INCREMENTAL PROFIT/(DECREMENTAL PROFIT) XXXX

SAMPLE PROBLEM 1:
Abra Corporation produces 3 main products. Its production and costs data are given
below:
X Y Z
Unit sales price after further processing P 300 P 550 P 220
Unit sales price before further processing P 250 P 530 P 190
Cost of separate/further processing P 120,000 P 65,000 P 190,000
Units produced and sold 2,000 4,000 7,500
Total joint costs are P1,400,000

Which of the products should be processed further?

SAMPLE PROBLEM 2:
Baguio Corporation produces 3 products at segregation point, K, M and T. These
products could be processed further then later sold at higher sales value. The total
joint cost in manufacturing these 3 products was P3 million. The data below were
made available by the accounting and production personnel:
K M T
Production and sales 10,000 units 40,000 units 50,000 units
Unit sales price at split-off point P 80 P 100 P 200
Unit sales price after further processing P 90 P 120 P 230
Unit variable costs of subsequent processing P 8 P 18 P 27

If product K is processed further, an equipment shall be rented at a cost of P12,000.

To process further product M, an outside contractor will be engaged for an amount of
P90,000 because the company has no available space and manpower for its subsequent
processing. Product T could be subsequently processed by using idle machine and
manpower time within the company. The total set-up cost of subsequently processing
further T is P120,000.

Required:
1. Which product/s should be processed further to maximize profit?
2. To maximize profit, what is the minimum sales price for product K that should be
set after it is processed further?
“CONTINUE OR DROP A SEGMENT/PRODUCT”

DATA ANALYSIS FORMAT OF THE ‘CONTINUE’ OR ‘DROP’ DECISION:

Revenue xxx
Less: Variable manufacturing costs xxx
Manufacturing margin xxx
Less: Variable operating expenses xxx
Contribution margin xxx
Less: Controllable direct fixed costs & expenses xxx
Controllable margin xxx
Less: Non-controllable direct fixed costs & expenses xxx
SEGMENT/DIVISION/DEPARTMENT/PRODUCT MARGIN XXX

OR Contribution margin xxx

Less: Avoidable fixed costs and expenses xxx
SEGMENT/DIVISION/DEPARTMENT/PRODUCT MARGIN XXX

SAMPLE PROBLEM 1:
Cagayan Company plans to discontinue a division with a P200,000 contribution to
overhead. Overhead allocated to the division is P500,000 of which P50,000 cannot be
eliminated. Should the company continue or drop the division?

SAMPLE PROBLEM 2:
Davao Company currently operates two divisions which had operating results for last
year’s operations ended December 31 as follows:
EAST DIVISION WEST DIVISION
Sales P 600,000 P 300,000
Variable costs 310,000 200,000
Contribution margin 290,000 100,000
Fixed costs for the Division 110,000 70,000
Division margin 180,000 30,000
Allocated common costs 90,000 45,000
Income/(Loss) from operation P 90,000 (P 15,000)

Since the West Division sustained an operating loss last year, Davao’s President is
considering the elimination of this division. Assume that the West Division’s direct fixed
costs could be avoided by 70% if this division will be eliminated and the facilities that
will be vacated by the division can be used by the company as storage space which will
save the company storage costs of P60,000 annually.
Would Davao Company eliminate or continue West Division’s operation? Why?
What would be the effect of your recommendation to the operating income of the
company for this year?

PREPARED BY:

Mrs. ARMI KATALBAS-BUYCO, CPA, MBA

Subject Professor
*****END*****