Differential

Analysis:
The Key to Decision
Making
Learning • Distinguish between relevant and
irrelevant costs and revenues in
Objectiv (alternative-choice) decisions.
es • Prepare analyses showing:
• whether to add or drop a segment
• whether to accept or reject a special
order
• whether to make or buy a component
• Rationing A Scarce Resource
• whether to sell or further process a
product
Types of Cost
Used In
Decision
Making
Types of Cost Used In Decision
Making
• A future cost • A future
that differs revenue that
between any differs
two between any
alternatives is two
known as a alternatives is
differential known as a
cost. differential
revenue.
Types of Cost Used In Decision Making

An incremental cost is

an increase in cost
An avoidable cost is a
between two
cost that can be
An opportunity cost is
alternatives.
eliminated by choosing
the potential benefit
one alternative over
that is given up when
another.
one alternative is
• A sunk cost is a cost that has already
been incurred and cannot be changed
regardless of what a manager decides
to do.
 Identifying Relevant Costs
• A manager at Purple Co. wants to replace an old machine with a
new one. What costs are relevant?
Identifying Relevant Costs

Other
Other fixed
fixed expenses
expenses areare the
the same;
same; book
book value
value of
of the
the old
old machine
machine
is
is aa sunk
sunk cost.
cost. They
They are
are not
not relevant.
relevant.
Decision
Making
Alternative Choices
 Types of Alternative-Choice
Decisions
A B C

Adding or Making or Accepting or

dropping a buying a rejecting a
product or component special
other (outsourcing order.
segments D
). F
Rationing of Sale versus
a scarce further
resource. processing.
Adding or Dropping a Segment
• Should we add or
drop a business
segment, such as a
product or a store?
• An add-or-drop
decision must be
based only on
relevant
EXAMPLE:
Purple Company has three product lines. The company is considering
dropping Product 2 because it has been operating at a loss. The following
summarizes the income of the three product lines.
Product Product Product TOTALS
1 2 3

Sales $15,000 $22,000 $37,000 $74,000

Less: Variable 9,000 10,000 19,000 38,000
Costs
Contribution $ 6,000 $12,000 $18,000 $36,000
Margin
Less: Fixed        
Costs
Traceable 3,000 10,000 6,000 19,000
 Product Product Product
1 2 3

Sales $15,000 $22,000 $37,000

Less: Variable 9,000 10,000 19,000
Costs
Contribution $ 6,000 $12,000 $18,000
Margin
Less: Fixed Costs      
Traceable 3,000 10,000 6,000
Net Income $ 3,000 $ 2,500 $ 12,000

Product 2 should not be dropped since it

has a positive segment margin.
 With Without
Product 2 Product 2
Sales $74,000 $52,000
Less: Variable Costs 38,000 28,000
Contribution Margin $36,000 $24,000
Less: Fixed Costs
Traceable 19,000 9,000
Allocated 9,500 9,500
Net Income $ 7,500 $ 5,500

If Product 2 is dropped, it will result in lower overall net

income. Hence, the product line should not be dropped.
 Accept or Reject - Special Orders

• There are times when a customer

places a special order for a large
volume at lower prices than that
usually charged by the business.
• In this event, the business should
properly decide whether to accept or
reject the special order. The rule is to
accept the order if benefits exceed
costs.
 Special Orders - Example
(With Excess Capacity)

• In a month, ABC Company normally

produces and sells 8,000 units of its
product for $20. Variable manufacturing
cost per unit is $10. Total fixed
manufacturing costs (up to the maximum
capacity of 10,000 units) are $38,000.
Variable operating cost is $1 per unit and
fixed operating costs total $10,000.
• A customer placed a special order for 1,500
units for $15 each. The customer is willing
to shoulder the delivery costs; hence the
 Without With
Special Order Special Order

Sales $160,000 $182,500

Less: Variable costs
Var. manufacturing 80,000 95,000
Var. operating 8,000 8,000
Yes. The selling
Contribution margin
price of $15
$72,000
exceeds the
$79,500
variable
Less: Fixed manufacturing
costs cost of $10. This
will result
Fixed in additional income
manufacturing 38,000 of 38,000
$7,500
Fixed operating 10,000 10,000
Operating Income
(1,500 x $5).
$24,000 $31,500
 Special Orders - Example
(Without Excess Capacity)

• Assume that the company normally

manufactures and sells 9,000 units instead
of 8,000. Should the company accept the
special order?
 Without With
Special Order Special Order

Sales $160,000 $192,500

Less: Variable costs
Var. manufacturing 90,000 100,000
Var. operating 9,000 8,500
Contribution margin $81,000 $84,000
Less: Fixed costs
Fixed manufacturing 38,000 38,000
Fixed operating 10,000 10,000
Operating Income $33,000 $36,000
• Contribution margin is equal to sales (at
$20) minus variable costs ($10 variable
manufacturing plus $1 variable operating).
• Lost contribution margin = ($20 - $11) x
500 units = $4,500
• The lost contribution margin is allocated
over the items sold through the special
order.
• Lost contribution margin per unit =
$4,500 / 1,500 units = $3
• Should the company accept the offer?
• The answer is still yes since the selling price
 Make or Buy

Businesses are sometimes faced with a

decision to choose between buying a
product that it uses in its operations
and making such product.
 Make or Buy - Example
Assume that Friends Company manufactures a product which
requires a particular type of valves. The company currently
purchases the valves from a supplier at a price of $5 per unit.
The company can also produce the valves internally. In the
coming year, the company anticipates a need for 10,000 of
such valves. If the company produces the valve internally, it
will incur the following costs:
Direct labor = $1/unit
Direct material = $2/unit
Variable overhead = $0.5/unit
 Make or Buy - Example
The manufacturing process for the valves would also require a
purchase of tooling which is typically used within a year. The cost
of such tooling for the 10,000 valves is $20,000.
Based on this information, Friends Company performs the following
analysis:
 Make or Buy - Example

From the table above, it will cost $55,000 to

manufacture 10,000 valves. At the same time,
it only costs $50,000 to buy the valves from
the supplier. Friends Company should
continue buying the valves from the supplier.
 Rationing A Scarce
Resource
• If the objective is to maximize the
company profit, a scarce resource
is best used to produce and sell
the product generating the highest
CM per unit of the scarce resource.
• This strategy assumes that the
company must ration only one
scarce resource.
 Rationing A Scarce Resource Example

• Active Company produces two products and

selected data is shown below.
A B
CM/unit $ 10 $ 12
Std. machine hrs/unit 1 hr. 2 hrs.
• If only10,000 machine hours are available,
which product should Active focus its
efforts on?
Rationing A Scarce Resource
Example
A B
CM/unit $ 10 $ 12
Std. requirement/unit 1 hr. 2 hrs.
CM/hour $10 $ 6
• Active should focus its attention on product A, if
only 10,000 machine hours are available:
Total CM = 10,000 * $10, if only A is produced
Total CM = 10,000 * $6, if only B is produced
Sale Versus Further Processing
• Should we sell our product at some
point before the final step in its
production?

• As a general rule, a product should

be further processed if the
incremental revenues from
processing exceed the incremental
ABC Company manufactures three products. In one production batch, the
company incurs $25,000 manufacturing costs up to the split off-point (the point
in the manufacturing process when the products can be separately identified).
The following summarizes the further processing costs beyond the split-off
point and ultimate sales value.

Further Expected
processing sales
costs revenue
Product 1 $72,000 $90,000
Product 2 $12,000 $28,000
Product 3 $2,000 $12,000
The company can sell the products at split-off
point. The expected sales revenues at split-off
point are: Product 1 - $24,000, Product 2 -
$8,000, Product 3 - $7,000.

Which products should be sold at split-off point

and which products should be processed
further?
 Product 1 Product 2 Product 3
Increase in $66,000 $20,000 $5,000
sales
Increase in 72,000 12,000 2,000
costs
Effect to ($6,000) $8,000 $3,000
profits

Product 1 should be sold at split-off point. The increase in sales revenue

amounting to $66,000 (i.e., from $24,000 to $90,000) is less than the costs to
process the product further ($72,000). Hence, it is better to sell the product
at split-off point than process it further. Product 2 and Product 3 could be
processed further since it will result in incremental profits.
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