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Ch. 10 Pt1- Differential Analysis (aka Incremental Analysis)

I. Introduction
A. Managerial accounting is a course that educates people in making good decisions.
B. This chapter in particular keys in on decision making in various business scenarios
C. Every decision involves choosing b/t alternatives. The costs and benefits of one alternative are compared
against the cost and benefits of another alternative.

II. Key Terms

A. Differential revenue- difference in revenue b/t 2 alternatives

B. Differential costs- difference in costs b/t 2 alternatives

C. Differential analysis- involves comparing different revenues and costs of 2 different alternatives

D. Relevant costs and Irrelevant costs

1. Relevant costs (a.k.a. avoidable costs or differential costs) - costs that differ b/t alternatives
2. Irrelevant costs (a.k.a. unavoidable costs)- costs that do not differ b/t alternatives. This information should
be ignored. Oftentimes, bad decisions factor in irrelevant costs.
3. Example
It’s Friday night. If you are trying to decide whether to go watch a live NBA basketball game or a live MLB
game, the rent for apartment is an irrelevant cost. With either alternative, you still have to pay rent for you
apartment. However, the costs of watching the NBA game or MLB game are relevant costs. Assuming you
only have time for one, you by choosing one option, you are avoiding the costs of the other option.

E. Sunk costs
1. A cost that has already occurred and cannot be avoided regardless of what you do. It is a type of irrelevant
cost.
2. Example
When I was a kid, my dad once had to decide whether to spend $5,000 to fix his $10,000 Buick station wagon
that constantly broke down or buy a new dependable Toyota Sedan for $9,000. He knows, most likely he may
have to do future repairs on the Buick-- costing another $5,000. In the end, he stuck with the Buick because he
already spent $3,000 on repairs in the past. My dad made a poor decision because he did not know about sunk
costs.

F. Opportunity cost
1. The foregone benefit of choosing one alternative over another. It is a type of relevant cost.
2. Example
Joe works for the supermarket. His boss tells him he can always come in to work at anytime even if he is not
scheduled to work. Suppose he makes $72 per day ($9 hourly rate after taxes X 8 hours in a day). In that case,
the opportunity cost of him taking a day off and going to the beach with his friends is $72 dollars.

III. Relevant Costs Practice Problem #1

A. Problem
Cate lives in Los Angeles and wants to visit her friend in San Francisco over the weekend (2 days). She is
deciding whether to drive or fly. The distance is 680 miles roundtrip. She has compiled a list of things she
thinks she needs to consider:
1. Auto Costs
Item Annual cost of fixed items Cost/Mile (based on 10k miles/yr)
a. Annual depreciation on car $2,800 $0.280
b. Cost of gas ($3.20 per gallon/32 miles 0.100
per gallon)
c. Annual cost of auto insurance and license $1,380 0.138
d. Repairs and maintenance 0.065
e. Reduction in resale value of car due to $0.026/mile
wear and tear

2. Other info.
f. Parking permit at her school ($45 X 8) $360 0.036
g. Cost of roundtrip shuttle service to airport in LA $50
h. Cost of roundtrip plane ticket $150
i. Cost of putting dog in kennel when gone $40
(assume she doesn’t want to take the dog along)
j. Cost of parking in SF. Once she arrives, you won’t drive. $20/day

She wants to choose the least expensive option. Perform the necessary calculations to show which option she
would choose. Should you drive or fly? How much would she save by taking the least expensive option? To
make things simple, let’s assume the amount of time for either option is the same.

B. Solution
1. The first thing you would do is to note which costs are relevant and irrelevant. Remember that irrelevant
costs are ignored.
a. Irrelevant
This is because depreciation is sunk cost. Here’s the logic. The original cost of the car is sunk cost.
Depreciation just spreads the original cost of the car over its useful life, but it is still sunk cost.

b. Relevant
Cost of gas is clearly a relevant cost. If she were to take fly, this cost would not incur.

c. Irrelevant
This is not relevant b/c whether or not she drives or flies, she still has to incur these expenses.

d. Relevant
Overall, the amount of R&M is proportionate to the # of miles driven. Hence, it is a relevant cost.

e. Relevant because if she were to fly, this cost would not incur.

f. Irrelevant
Parking at school is an irrelevant cost b/c she has to pay for parking at school regardless of either option.

g. Relevant because if she were to fly, this cost would incur.

h. Relevant, b/c if she drove she wouldn’t have to pay for the plane tickets

i. Irrelevant, b/c she would have to put her dog there in either case.

j. Cost of parking in the city is relevant b/c if she took the plane, this cost would not occur.
2. After you decide which costs are relevant and irrelevant, you would list the relevant costs in 2 columns based
on the 2 options and perform the necessary math.
Relevant Cost Relevant Cost
of Driving of Flying
Gas (680 miles X $0.10/mile) $(68.00)
R&M (680 miles X $0.065/mile) $(44.20)
Reduction in resale value (680 miles X
$(17.68)
$0.026/mile)
Cost of roundtrip shuttle service to airport in LA $(50.00)
Cost of parking in San Francisco (2 days @
$(40.00)
$20/day)
Cost of roundtrip plane ticket   $(150.00)
Total $(169.88) $(200.00) $30.12

$200.00 - $169.88 = $30.12 in favor of driving

So it would be $30.12 cheaper to drive than to fly.

So it would be $_________cheaper to ________________ than to _______________.

3. What are some other non-quantitative factors that she might consider in her decision making?

IV. Relevant Costs Practice Problem #2

A. Problem
Woodworks, Inc. is considering getting a machine that costs $3,000 to rent annually. However, it would reduce
the direct labor cost per unit by $3/unit. Here is a list of data gathered:

Current Situation Situation w/ new machine

Units produced and sold 5,000 5,000
Selling price per unit $40 $40
DM cost/unit $14 $14
DL cost/unit $8 $5
Variable OH cost/unit $2 $2
Fixed costs, other $62,000 $62,000
Fixed costs, new machine 0 $3,000

Should Woodworks, Inc. rent the machine? If so, how much annual savings will it get?

B. Solution
1. Method 1- (The long way method)- Had you not taken this class you would have probably done this. This
method takes too long. You should NOT use this method on the exam. Otherwise, you will not finish in
time.

Current Situation Situation w/ new machine Diff. Costs & Benefits

Sales (5,000 units X $40/unit) $200,000 $200,000
Less VC
DM (5,000 units X $14/unit) (70,000) (70,000)
DL (5,000 units X $8 or $5/ unit) (40,000) (25,000) 15,000
VC OH (5,000 units X $2/unit) (10,000) (10,000)
Total VC (120,000) (105,000)
CM 80,000 95,000
Less FC
Other (62,000) (62,000)
New machine rent 0______ (3,000) (3,000)
Total FC (62,000) (65,000)
Net Oper. Income $18,000 $30,000 $12,000

2. Method 2- (Method focusing on the relevant costs)

This is the method you should be using on your exams so that you can efficiently solve your problems.

Current Situation w/
Situation new machine

DL cost ($8X5,000) ($5 X 5,000) (40,000) (25,000)

Cost of renting new
machine   (3,000)
12,000 annual savings in favor of renting
(40,000) (28,000) new machine

40,000 – 28,000 = 12,000 annual savings in favor of renting new machine