Chapter 26

Short-Run
Alternative
Choice
Decisions

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Highlights

• Alternative choice decisions: manager

seeks to choose best out of several
alternatives.
• Introduces construct of differential costs
and revenues for several types of
problems, each having a relatively short
time horizon.

26-2
 Differential Costs and
Revenues

• Costs that are different under one set of

conditions than under another.
• Revenues that are different under one set
of conditions than under another.

26-3
 Nature of Full and
Differential Costs

• Full cost of a product or other cost object =

sum of direct cost + fair share of
applicable indirect costs.
• Differential costs include only those
elements of cost that are different under a
certain set of conditions.

26-4
 Source of Data for Full and
Differential Costs
• Full costs come from a company’s cost
accounting system.
• No comparable system for collecting
differential costs.
• Differential costs are assembled to meet
analytical requirements of a specific
problem.

26-5
 Historical, Full and
Differential Costs
• Full cost accounting system collects
historical costs.
• Differential costs relate to future.
• Differential costs show what costs will be if
a certain course of action is adopted.

26-6
 Contribution Analysis
• A tool for analyzing differential costs.
• Focuses on contribution margin.
• Contribution for a company (or for a
product line, division, or other segment of
a company) is the difference between its
total revenue and its total variable costs.

26-7
 Variable and Fixed Costs

• Variable costs (or expenses) are variable

because they vary proportionately with
volume of activity, such as sales.
• Fixed costs = in total do not vary with
activity (within relevant range).

26-8
 Direct and Indirect Costs

• Direct costs = costs that are traced directly

to cost object.
• Indirect costs = costs that are not traced
directly to cost object.

26-9
 Alternative Choice Problems

• 2 or more possible alternative courses of action.

• Manager chooses best alternative.
• Some choices may be quantified, but this is only
one aspect of analysis and may not be most
important factor.

26-10
 Objective of Alternative
Choice Problem
• Seek alternative most likely to achieve
objectives of organization.
• In a profit oriented business:
– Maximizing value of shareholders’ investment by
making alternative choices that earn a satisfactory
return on investment.
– Return on investment is usually measured using an
accounting and not a market-determined measure of
return.
– Other factors are also likely to influence decision.

26-11
 Steps in the Analysis
• Define problem.
• Select possible alternative solutions including
status quo.
• For each alternative, measure and evaluate
consequences in quantitative terms.
• Identify consequences that cannot be expressed
in quantitative terms.
• Evaluate measured quantitative and non-
quantitative consequences.
• Make decision.

26-12
 Differential Costs

• Out of pocket costs = avoidable costs =

costs that will be different under the
proposed alternative than they are in the
base case.
• No general category of costs can be
labeled differential.
• Always relates to specific alternatives
being analyzed.

26-13
 Mechanics of Calculation

• No prescribed format; use most

convenient.
• Cost items unaffected by decisions are not
differential and may be disregarded (or
treated the same under each alternative).

26-14
 Opportunity costs
• Value lost or sacrificed by giving up an
alternative course of action.
• Not associated with cash outlays.
• Not measured in accounting records.
• If an alternative requires resources that would
otherwise be used for income producing
purposes, opportunity cost is measured by
income that would have been earned had
resources been invested otherwise.
• Iffy costs.

26-15
 Differential Costs
• Differential costs = incremental costs = relevant costs =
out-of-pocket costs = avoidable costs
• = variable costs(=marginal costs), if all alternatives
involve operating at different volume levels within the
relevant range.
• May also include fixed costs if any alternative results in
changes in step-function costs.
• Future costs, which may be best estimated by looking at
past/historical costs.
• Usually estimates are not precise unless determined by
contract.

26-16
 Sunk Cost
• = a cost that has already been incurred and
therefore cannot be changed by any decision
currently being considered.
• e.g. all historical costs.
• Not a differential cost.
• If asset is used it is depreciated, if it is disposed
of it is written off, in either event it is expensed.

26-17
 Disposal Value

• Relevant and differential cost/revenue if

one alternative is to keep equipment and
another alternative is disposal.

26-18
 Importance of Time Span

• To make only one additional unit, only material

cost may be differential.
• To produce an item over foreseeable future, all
items of production cost would be differential.
• The longer the time span the more items of cost
are differential.
• In the very long run full costs are differential
costs.

26-19
 Types of Alternative Choice
Problems

• Problems involving Costs.

• Problems involving revenues and costs.
• Differential investments.

26-20
 Problems Involving Costs

• One type of cost is traded for another.

• Change of method of operation.
• Make or buy decisions.
• Economic order quantity decision.
– Trade off setup costs and inventory carrying
costs.

26-21
 Problems Involving both
Revenues and Costs
• Best alternative has most differential
income or profit.
• Supply and demand analysis.
• Contribution pricing.
• Discontinuing a product.
• Adding a service.

26-22
 Supply and Demand
Price Analysis

• Compare revenue and expense at various

prices, after considering affect on volume,
revenue and costs.

26-23
 Contribution Pricing

• Full cost is normal basis for setting price.

• Orders may be accepted when differential
revenues exceed differential costs.
– Such a selling price is called a contribution price to
distinguish it from a normal price.
– A version of this is referred to as dumping and may
be illegal .

26-24
 Other Problems Involving
Both Revenues and Costs
• Discontinuing a product.
– Adding services such as a grocery store
opening on Sundays, a fast food restaurant
opening for breakfast.
• Sale versus further processing.
• Other marketing tactics such as
consolidating warehouses, how often to
call on customers.

26-25
 Differential Revenues, Costs,
and Investment Problems
• In addition, to revenues and costs,
considers changes on investment
associated with alternatives.
• Consider changes in current assets (e.g.
accounts receivable, inventories) and
current liabilities (e.g. accounts payable).
• Covered in Chapter 27.

26-26
 Sensitivity Analysis

• Considers how sensitive quantitative

measurements of alternatives are to
changes in assumptions.

26-27
 “Just One” Fallacy

• Each additional unit of production adds

just variable costs.
• If many units are added step function
costs (i.e. fixed costs) are added.
• Therefore, step function costs are
averaged out over the additional units of
volume.

26-28
 Expected Values

• Discussion has assumed single point

estimates, that is, best estimates.
• Alternative is to use separate possibilities
weighted by probabilities to determine
expected values.
– Choose alternative with highest expected
value.

26-29
 Decision Tree Analysis

• Diagram shows several decisions, or acts,

and possible consequences.
• Revenues and costs are estimated with
probabilities for each outcome to give an
expected value for event.

26-30
 Practical Pointers
1. Use imagination.
2. Don’t overweight quantitative factors.
3. Don’t slight approximations.
4. Work with total not unit costs when
possible.
5. Tendency to underestimate costs with
something new.

26-31
 Practical Pointers (continued)
6. Don’t overweight number of arguments
rather substance.
7. Consider margin of error.
8. Delaying too long to decide is a decision.
9. Identify assumptions & sensitivity
analysis.
10. Do not expect conclusion to be accepted
just because numbers are worked out.
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 Summary Comment

• Differential costs and revenues rarely

provide answer to any business problem,
but facilitate a sound decision.

26-33
 Chapter 26

End of
Chapter 26

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.