220 Chapter 7 Differential Cost Analysis for Operating Decisions

The Differential Principle

Managers make decisions by choosing among alternatives. Each alternative represents a set of
activities that will result in costs and profits. The differential analysis model, shown in Exhibit 7.1,
extends the financial model discussed in Chapter 6.
The column labeled ‘‘Alternative’’ represents the alternative being considered. The next
column to the right presents the status quo, or the outcome expected if management makes no
change. The far right column shows the difference between the status quo and the alternative. If
the difference is such that profit1 > profit0, the alternative is more profitable than the status quo. If
profit0 > profit1, the status quo is more profitable. A differential cost is a cost that changes (differs)
as a result of changing activities or levels of activities.
The following example illustrates differential analysis. To provide continuity, we use the facts
from this example throughout the chapter. We use a manufacturing firm in this illustration
because it is the most comprehensive and complex of any type of organization. The concepts
apply just as much to service, financial, merchandising, and other organizations.

Example
Assume the following status quo data for Ullman Educational Media, a company that produces
tutorial videos for primary and preschool use.

SP 30 25 Units Made and Sold ........................................................................................................ 800 Units per Month

VC 22 22 Maximum Production and Sales Capacity .................................................................... 1,200 Units per Month
Selling Price........................................................................................................................ $30
CM 8.00/unit 3
Variable Cost Fixed Cost
Activity Classification and Resulting Costs (per unit) (per month)

Manufacturing .............................................................................................................. $17 $3,060

Marketing and Administrative .................................................................................. 5 1,740
Total Costs .................................................................................................................... $22 $4,800

The management of Ullman Educational Media believes that it can increase volume from
800 units to 900 units per month by decreasing the selling price from $30 to $28 per unit. Would
the price reduction be profitable? The differential analysis for this example indicates that the
alternative would not increase profits. Exhibit 7.2 shows the alternative’s profit is only $600,
whereas the status quo generates $1,600 in profits.

R ELEVANT C OS TS
Note in Exhibit 7.2 that this particular alternative does not affect all costs. Specifically, fixed costs
from manufacturing, marketing, and administrative activities in this example do not change. Thus,
only revenues and total variable costs are relevant to the analysis; fixed costs are not. We sometimes
call differential analysis relevant cost analysis as it identifies only the costs (or revenues) relevant
to the decision. A cost or revenue is relevant if an amount appears in the Difference column; all

EXHIBIT 7.1 Differential Analysis Model

Alternative
Status Quo ¼ Difference

Revenue .............................................. Revenues1
Revenues0 ¼ Change in Revenues

Less Variable Costs ........................... Variable Costs1
Variable Costs0 ¼ Change in Variable Costs
Total Contribution Margin (CM) .... CM1
CM0 ¼ Change in CM
Less Fixed Costs ................................ Fixed Costs1
Fixed Costs0 ¼ Change in Fixed Costs
Operating Profit ................................ Profit1
Profit0 ¼ Change in Profit
 Major Influences on Pricing 221

ULLMAN EDUCATIONAL MEDIA

EXHIBIT 7.2
Differential Analysis of a Price Reduction

Alternative
Status Quo ¼ Difference

Price ¼ $28 Price ¼ $30
Units ¼ 900 Units ¼ 800

Revenue ..................................................................... $25,200a
$24,000c ¼ $1,200 higher

Less Unit-Level Costs (Variable) .......................... 19,800b
17,600d ¼ 2,200 higher
Total Contribution Margin ..................................... $ 5,400
$ 6,400 ¼ $1,000 lower
Less Facility-Level Costs (Fixed) ......................... 4,800
4,800 ¼ 0
Operating Profit ....................................................... $ 600
$ 1,600 ¼ $1,000 lower

a
$25,200 ¼ $28  900 Units.
b
$19,800 ¼ $22  900 Units.
c
$24,000 ¼ $30  800 Units.
d
$17,600 ¼ $22  800 Units.

others are irrelevant. Thus, we could ignore fixed costs in this example. (This is not true in general.
Fixed costs nearly always differ in long-run decisions involving changes in capacity, and they
sometimes differ in short-run operating decisions, as we shall see later in this chapter.)
As you become familiar with differential analysis, you will find shortcuts by ignoring
irrelevant costs (or revenues). For instance, you needed to work only with revenues and total
variable costs in the previous example to get the correct answer.

F OCUS ON C ASH F LOWS

Differential analysis uses cash flows instead of accrual accounting numbers for two reasons:
1. Cash is the medium of exchange in business.
2. Cash is a common, objective measure of the benefits and costs of alternatives.
Consequently, differential analysis focuses on differential cash flows caused by changes in
activities. The previous example assumed both differential revenues and costs to be cash flows or
near-cash flows (e.g., it assumed that revenues and costs on account are cash flows).

UNCERTAINT Y AND D IFF ERENTIAL ANALYS IS

Cost and revenue estimates for the status quo are usually more certain than estimates for alter-
natives. The status quo represents something known, whereas estimates for alternatives may be
little more than educated guesses. When considering an alternative, the types of activities, the
level of activities, and the cost of activities are all estimates subject to error. Analysts may easily
omit some critical aspect of the alternative.
Most managers dislike risk and bear risk only if compensated. They prefer the known to the
unknown, all other things being equal. Consequently, managers sometimes reject, because of risk,
an alternative expected to be more profitable than the status quo. Managers often deal with risk
and differential analysis by setting high standards for the alternative. For example, ‘‘The alter-
native must increase profits by 25 percent before we will accept it.’’ Some organizations set
incentives for managers to take risks in these situations.

Major Inf luences on Pricing

In making pricing decisions, companies weigh customers, competitors, and costs differently.
Companies selling homogeneous products in highly competitive markets must accept the market
price. Managers setting prices in markets with little competition, however, have some discretion.
The pricing decision considers the value customers place on the product, the pricing strategies of
competitors, and the costs of the product. Companies have become customer driven, focusing on
222 Chapter 7 Differential Cost Analysis for Operating Decisions

delivering quality products at competitive prices. The three major influences on pricing decisions
are customers, competitors, and costs:

Customer Competitors’
Demands Actions

Pricing
Decisions

Costs
of Product

CUS TOMERS
Managers examine pricing problems through the eyes of their customers. Increasing prices may
cause the loss of a customer to a competitor, or it may cause a customer to substitute a less
expensive product.

C OMP E TITORS
Competitors’ reactions also influence pricing decisions. A competitor’s aggressive pricing may
force a business to lower its prices to compete. On the other hand, a business without any
competitors can set higher prices. If a business has knowledge of its competitors’ technology,
plant capacity, and operating policies, it is able to estimate the competitors’ costs, which is
valuable in its own pricing decisions.
Increasingly, managers consider their domestic and international competition in making
pricing decisions. Firms with excess capacity because of low demand in domestic markets may
price aggressively in their export markets. For instance, a software development company such as
Microsoft, with high development costs and low variable costs, may seek out foreign markets. In
a foreign market the company can exploit the high development costs already incurred while
pricing lower than local competitors, who must incur high development costs before they can
produce anything.

C OS TS
A product that is consistently priced below its cost can drain large amounts of resources from an
organization. Financial modeling assists in measuring the profits that result from different
combinations of price and output sold for a particular product.
Pricing is an area where newly evolving themes, such as customer satisfaction, continuous
improvement, and the dual internal/external focus, come together. For instance, lower prices for
quality products are conducive to customer satisfaction—an external focus. But when prices drop,
costs must be reduced as well. The internal focus on continuous improvement is the key to cutting costs.

Shor t-Run versus Long -Run Pricing De cisions

The time horizon of the decision is critical in computing the relevant costs in a pricing decision.
The two ends of the time-horizon spectrum are

Short-Run Long-Run

Pricing Decisions Pricing Decisions

 Differential Approach to Pricing 223

ULLMAN EDUCATIONAL MEDIA

EXHIBIT 7.3
Differential Analysis of a Special Order

Alternative
Status Quo ¼ Difference

Revenue ....................................................................................... $26,500a
$24,000 ¼ $2,500 higher

Less Unit-Level Costs (Variable) ............................................ 19,800b
17,600 ¼ 2,200 higher
Total Contribution Margin ....................................................... $ 6,700
$ 6,400 ¼ $ 300 higher
Less Facility-Level Costs (Fixed) ........................................... 4,800
4,800 ¼ 0
Operating Profit ......................................................................... $ 1,900
$ 1,600 ¼ $ 300 higher

a
$26,500 ¼ $24,000 þ ($25  100 Units).
b
$19,800 ¼ $17,600 þ ($22  100 Units).

Short-run decisions include pricing for a one-time-only special order with no long-term
implications. The time horizon is typically six months or less. Long-run decisions include pricing
a main product in a major market. For example, a special order to Nike for shoes for an athletic
team would be a short-run pricing decision, whereas introducing a new type of running shoe to
the market would be a long-run pricing decision.

A. S HORT-RUN P RICING D ECIS IONS : S P ECIAL ORDERS

The differential approach helps in making special-order decisions. For example, assume Ullman
Educational Media has an opportunity to make a one-time sale of 100 units at $25 per unit to a
state prison system. Exhibit 7.3 presents an analysis of the effects of accepting the special order or
not. Assume the regular market is 800 units sold at a price of $30 per unit. Exhibit 7.3 dem-
onstrates that Ullman should accept the special order at $25 per unit because that price permits the
firm to cover the differential costs of $22 per unit and provide a contribution of $3 per unit toward
covering fixed costs and earning a profit.

Differential Approach to Pricing

The differential approach to pricing is useful for both short-run and long-run decisions. It pre-
sumes that the price must at least equal the differential cost of producing and selling the product.
In the short run, this practice will result in a positive contribution to covering fixed costs and
generating profit. In the long run, the practice will require covering all costs, because both fixed
and variable costs become differential costs in the long run.
Consider the data for Ullman Educational Media in Exhibit 7.4. The minimum acceptable
price in the short run is the differential cost of $22 per unit. In the long run, the minimum
acceptable price is $28 per unit because the firm must cover both variable and fixed costs. A more
desirable long-run price is the current price, $30, which provides a profit. The firm may set a price
slightly higher than the variable cost for a special order as long as excess capacity exists and
doing so will not affect the firm’s regular market.

ULLMAN EDUCATIONAL MEDIA

EXHIBIT 7.4
Data for Pricing

Short-Run Differential Costs (variable costs)........................................... $22 ¼ Short-Run Minimum Price

Fixed Cost.......................................................................................................... 6a
Long-Run Incremental Costs ........................................................................ $28 ¼ Long-Run Minimum Price
Expected Profits............................................................................................... 2
Target Selling Price ......................................................................................... $30 ¼ Long-Run Desired Price

a
$6 ¼ $4,800/800. This assumes a long-run volume of 800 units.
224 Chapter 7 Differential Cost Analysis for Operating Decisions

Suppose Ullman Educational Media wants to price aggressively. It can set a price slightly higher
than the $22 minimum. Managers hope to underprice competitors and to capture a larger share of
the market. If the firm is the only supplier of this product, it can charge a price higher than $28. If
the firm sets the price too high, however, its high profits may entice competitors into the market.

Problem 7.1 for Self-Study

APPLYING DIFFERENTIAL ANALYSIS. Domer Technologies, Inc., produces a valve used in electric
turbine systems. The costs of the valve at the company’s normal volume of 5,000 units per
month appear below. Unless otherwise specified, assume a selling price of $1,750 per unit.

Cost Data for Domer Technologies

Unit-Level Costs (5,000 units)

Materials ($250 per unit) .............................................................................................................. $1,250,000
Labor ($175 per unit) .................................................................................................................... 875,000
Overhead ($75 per unit) ................................................................................................................ 375,000
Total Unit-Level Costs ................................................................................................................ $2,500,000
Customer-Level Costs (200 customers)
Meetings with Customers ($5,000 per customer) .................................................................... 1,000,000
Facility-Level Costs
Factory and Related Costs (fixed) ............................................................................................... 1,625,000
Total Costs .................................................................................................................................... $5,125,000

Market research estimates that a price increase to $1,900 per unit would decrease monthly
sales volume to 4,500 units. The accounting department estimates total unit-level costs
would decrease proportionately with volume. Total customers would decrease from 200 to
185 customers, and total facility-level costs would decrease from $1,625,000 to $1,617,500.
Would you recommend that the firm take this action? What would be the impact on
monthly revenues, costs, and profits?
The solution to this self-study problem is at the end of the chapter on page 241.
234 Chapter 7 Differential Cost Analysis for Operating Decisions

B. Joint Produc ts : S ell or Process Fur ther

Suppose you get multiple products from a single production process. For example, Georgia-
Pacific gets various wood products from its lumber mills. Dairy producers such as Borden and
Land O’Lakes get multiple products from raw milk.
Exhibit 7.11 presents the following information graphically. The firm initially introduces
direct materials into processing. After incurring direct labor and manufacturing overhead costs,
two identifiable products, Product A and Product B, emerge from the production process. The
firm processes Product A further but sells Product B immediately. We call the point at which the
identifiable products emerge the splitoff point. Costs incurred up to the splitoff point are the joint
costs. We call costs incurred after the splitoff point additional processing costs.
Companies producing joint products must decide at each splitoff point whether to sell the
individual products as they are or process further. Differential analysis is appropriate for these
types of decisions.

Example
At Hanson Dairy, the cows produce 10,000 gallons of raw milk per month. After milking,
separating, and processing, which costs $11,000, the dairy has 7,000 gallons of whole milk and
3,000 gallons of cream. The milk could be sold at this point for $1.00 per gallon or processed
further into 6,500 gallons of nonfat milk, with 500 gallons lost in the process. Further processing
would cost $0.20 per gallon for the 6,500 gallons of output. The nonfat milk could then be sold
for $1.25 per gallon. The cream could also be sold or processed further into sour cream, butter,
and cheese.
The following is an analysis considering whether to process the milk further or sell now. The
initial $11,000 is a joint cost and not differential for this decision. The differential costs are the
additional processing costs of $0.20 per gallon.

Alternative: Process
Status Quo: ¼ Difference

Further Sell

Revenue ................................................................ $8,125
$7,000 ¼ $1,125 higher

Less Additional Processing Costs ................... 1,300
0 ¼ 1,300 higher
Contribution Margin before Costs Prior to
Split off Are Considered ............................... $6,825
$7,000 ¼ $ 175 lower

Of the joint products milk and cream, the milk should not be processed further. Costs to process
the milk further would exceed expected revenues. The company could perform the same analysis
for the cream.

EXHIBIT 7.11 Joint Production Process

Additional
Processing Costs
Incurred Sale of
Product A
Joint Costs:
Direct Materials
Direct Labor
Overhead

Sale of
Product B
Splitoff Point
232 Chapter 7 Differential Cost Analysis for Operating Decisions

Although this alternative would increase profits, it would not increase profits by as much as
alternative 2.

THEORY OF C ONS TR AINTS AND C OS T A S SUMP TIONS

The theory of constraints assumes few costs are variable—generally only materials, purchased
parts, piecework labor, and energy to run machines. Most direct labor and overhead costs are
assumed to be fixed. This is consistent with the idea that the shorter the time period, the more
costs are fixed, and the idea that the theory of constraints focuses on the short run. Generally, this
assumption about cost behavior seems reasonable.

THEORY OF C ONS TR AINTS , TOTAL QUALIT Y

M ANAGEMENT, AND JUS T- IN -T IME
The theory of constraints identifies bottlenecks and possible disruptions that threaten throughput.
When disruptions are hard to pinpoint or eliminate, quality control techniques from total quality
management (TQM) may be utilized. Total quality management stabilizes and improves pro-
cesses to decrease variation; it is well suited to removing disruptions in the process. One manager
summarized the relations among recent management techniques well by saying, ‘‘Essentially, JIT
(just-in-time) improves lead times and due-date performance, TQM (total quality management)
improves people, and TOC (theory of constraints) provides focus for the entire improvement
process.’’3

C. Make - or-Buy De cisions

A firm facing a make-or-buy decision must decide whether to meet its needs internally or to
acquire goods or services from external sources, which is often called outsourcing. If Pillsbury
grows its own farm products for its frozen foods, then it ‘‘makes.’’ If it buys products from other
farmers, then it ‘‘buys.’’ Housing contractors who do their own site preparation and foundation
work ‘‘make,’’ whereas those who hire subcontractors ‘‘buy.’’ Professional baseball teams that
rely on the draft and their minor league system ‘‘make,’’ whereas those that trade for established
players ‘‘buy.’’
Whether to make or to buy depends on cost factors and on nonquantitative factors such as
dependability of suppliers and the quality of purchased materials.

Managerial Application
Cost Management in Action: Why Hewlett-Packard Now Manages Suppliers Instead of Overhead
A division of Hewlett-Packard was one of the early that drove overhead costs. The result was that overhead
experimenters with activity-based costing. Because costs decreased substantially, but the cost of goods
overhead costs were more than 50 percent of total purchased from suppliers increased to 70 percent of total
product costs, managers wanted to identify the activities product cost. The emphasis shifted from managing
that drove overhead costs. Based on the costs of overhead costs to managing supplier relations.
activities revealed by activity-based costing,
management decided to outsource many of the activities Source: Interviews with Hewlett-Packard managers.

3
E. Noreen, D. Smith, and J. Mackey, The Theory of Constraints and Its Implications for Management Accounting
(Great Barrington, Mass.: North River Press, 1995), p. 42.
 Make-or-Buy Decisions 233

BEN & JERRY COOKIE COMPANY

EXHIBIT 7.10
Differential Analysis of Make-or-Buy Decision

Alternative:
Status Quo: ¼ Difference

Buy Make

Revenue ....................................................................................... $24,000
$24,000 ¼ 0

Less:
Variable Costs to Produce and Sell................................... 8,800a
17,600 ¼ $8,800 lower
Variable Costs of Goods Bought ........................................ 9,600b
--- ¼ 9,600 higher
Total Contribution Margin .................................................. $ 5,600
$ 6,400 ¼ $ 800 lower
Less Fixed Costs ......................................................................... 3,840
4,800 ¼ 960 lower
Operating Profit ......................................................................... $ 1,760
$ 1,600 ¼ $ 160 higher

a
$8,800 ¼ $11  800 Units.
b
$9,600 ¼ $12  800 Units.

Example
The Ben & Jerry Cookie Company has an opportunity to buy part of its product for $12 per unit.
This purchase would affect prices, volume, and costs as follows:

Alternative: Status Quo:

Buy Make

Unit Selling Price ....................................................................................... $ 30 $ 30

Volume .......................................................................................................... 800 per Month 800 per Month
Unit Variable Costs .................................................................................... $ 11 $ 22
Purchased Ingredients, per Unit ............................................................ $ 12 $ 0
Total Fixed Costs ........................................................................................ $3,840 $4,800

Exhibit 7.10 shows that the alternative to buy is more profitable. The $9,600 cost to buy is more
than offset by the fixed and variable cost savings.

Problem 7.3 for Self-Study

MAKE-OR-BUY DECISION. Assume the Franklin Company, which manufactures wood stoves,
has an opportunity to buy the handles for its stoves for $8 per unit. This purchase would
affect prices, volume, and costs as follows:

Buy Make

Unit Selling Price ............................................................................................ $ 340 $ 340

Volume (per month) ....................................................................................... 500 500
Unit Variable Costs ......................................................................................... $ 88 $ 95
Purchased Parts (per unit)............................................................................ $ 8 $ 0
Fixed Costs ........................................................................................................ $4,700 $5,500

Management wants you to decide whether the part should be made or bought.
The solution to this self-study problem is at the end of the chapter on page 242.
 Adding and Dropping Parts of Operations 235

Problem 7.4 for Self-Study

SELL OR PROCESS FURTHER. The Demi Company processes logs into 200,000 board feet of
lumber and 50,000 board feet of scrap lumber per year. The scrap lumber can be sold at
splitoff for $5 per board foot or processed further into plywood to be sold for $6 per board
foot. Further processing would incur variable costs of $0.50 per board foot. The equipment
and space to process the scrap lumber would increase fixed costs by $25,000 per year.
Management wants you to decide whether the scrap lumber should be sold or processed
further.
The solution to this self-study problem is at the end of the chapter on page 242.

D Adding and Dropping Par ts of Op erations

Managers must decide when to add or drop products from the product line and when to open or
abandon sales territories. For example, Microsoft decided to drop certain networking products.
Sears decided to eliminate certain real estate and financial services operations. Tower Records
closed many of its large retail stores.
These can be either long-run decisions involving a change in capacity or short-run decisions
in which capacity does not change. This chapter deals with these short-run decisions.
The differential principle implies the following rule: If the differential revenue from the sale
of a product exceeds the differential costs required to provide the product for sale, then the
product generates profits and the firm should continue its production. This decision is correct even
though the product may show a loss in financial statements because of overhead costs allocated to
it. If the product’s revenues more than cover its differential costs, and if no other alternative use of
the production and sales facilities exists, the firm should retain the product in the short run.

Example
Suppose that the Baltimore Company had three products and used common facilities to produce
and sell all three. No single product affects sales of the others. The relevant data for these three
products follow:

Product

A B C Total

Sales Volume per Month ........................................ 800 1,000 600 ---

Unit Sales Price ....................................................... $ 30 $ 20 $ 40 ---
Sales Revenue .......................................................... $24,000 $20,000 $24,000 $68,000
Unit Variable Cost ................................................... $ 22 $ 14 $ 35 ---
Fixed Cost per Month ............................................. --- --- --- $13,600

Management has asked the accounting department to allocate fixed costs to each product so
that it can evaluate how well each product is doing. Total fixed costs were 20 percent of total
dollar sales, so the accountant charged fixed costs to each product at 20 percent of the product’s
sales. For example, Product C received $4,800 (¼ 0.20  $24,000 sales) of fixed costs.
The product-line income statements in the top panel of Exhibit 7.12 show an apparent loss of
$1,800 for Product C. One of Baltimore’s managers argued, ‘‘We should drop Product C. It is
losing $1,800 per month.’’ A second manager suggested performing a differential analysis to see
the costs saved and revenues lost. The bottom panel of Exhibit 7.12, the differential analysis,
shows dropping Product C reduces the company’s profits. The first manager incorrectly assumed
that dropping the product would save fixed costs.
The firm should investigate more profitable uses of the facilities used to produce and sell
Product C, because its contribution margin appears to be the weakest of the three products. Until
such alternatives emerge, however, producing and selling Product C is profitable.
236 Chapter 7 Differential Cost Analysis for Operating Decisions

BALTIMORE COMPANY
EXHIBIT 7.12
Differential Analysis of Dropping a Product

INCOME STATEMENT ANALYSIS

Product

A B C Total

Sales ........................................................................... $24,000 $20,000 $24,000 $68,000

Less Variable Costs .................................................. 17,600 14,000 21,000 52,600
Total Contribution Margin ..................................... $ 6,400 $ 6,000 $ 3,000 $15,400
Less Fixed Costs Allocated to Each Product ..... 4,800a 4,000a 4,800a 13,600
Operating Profit (Loss) .......................................... $ 1,600 $ 2,000 $(1,800) $ 1,800

DIFFERENTIAL ANALYSIS
Alternative:
Status Quo ¼ Difference
Drop Product C

Sales ...................................................................... $44,000
$68,000 ¼ $24,000 lower

Less Variable Costs ............................................. 31,600
52,600 ¼ 21,000 lower
Total Contribution Margin ................................ $12,400
$15,400 ¼ $ 3,000 lower
Less Fixed Costs .................................................. 13,600
13,600 ¼ 0
Operating Profit (Loss) ..................................... $ (1,200)
$ 1,800 ¼ $ 3,000 lower

a
Fixed costs of $13,600 allocated in proportion to sales.

Problem 7.5 for Self-Study

PRODUCT DECISIONS. Assume Baltimore Company did not drop Product C, but Product B’s
revenue and variable costs dropped to 50 percent of the levels shown in Exhibit 7.12. Should
Baltimore drop Product B?
The solution to this self-study problem is at the end of the chapter on page 242.

Inventory Management De cisions

Inventory management affects profits in merchandising, manufacturing, and other organizations

with inventories. Having the correct type and amount of inventory can prevent a production
shutdown in manufacturing. In merchandising, having the correct type of merchandise inventory
may mean making a sale. Inventories are costly to maintain, however. The costs include storage
costs, insurance, losses from damage and theft, property taxes, and the opportunity cost of funds
tied up in inventory. Key inventory management questions include the following:
1. How many units of inventory should be on hand and available for use or sale?
2. How often should the firm order a particular item? What is the optimal size of the order?

D IFF ERENTIAL C OS TS F OR INVENTORY M ANAGEMENT

Inventory management decisions involve two types of opposing costs. The firm incurs differ-
ential costs each time it places an order or makes a production run (e.g., the cost of processing
each purchase order or the cost of preparing machinery for each production run). These are
Sample Problems :
PROBLEM# 1

PROBLEM# 2