Differential Cost analysis

Differential cost analysis is a management accounting toolkit that helps managers reach
decisions when they are posed with the following questions:

1. Whether to buy a component from an external vendor or manufacture it in house?

2. Whether to accept a special order?
3. What price to charge on a special order?
4. Whether to discontinue a product line?
5. How to utilize the scarce resource optimally? etc.

DCA is an incremental analysis which means that it considers only relevant costs i.e. costs
that differ between alternatives and ignores sunk costs i.e. costs which have been incurred,
which cannot be changed and hence are irrelevant to the scenario.

Example
Company A manufactures bicycles. It can produce 1,000 units in a month for a fixed cost
of $300,000 and variable cost of $500 per unit. Its current demand is 600 units which it
sells at $1,000 per unit. It is approached by Company B for an order of 200 units at $700
per unit. Should the company accept the order?

Solution

A layman would reject the order because he would think that the order is leading to loss
of $100 per unit assuming that the total cost per unit is $800 (fixed cost of $300,000/1,000
and variable cost of $500 as compared to revenue of $700).

On the other hand, a management accountant will go ahead with the order because in
his opinion the special order will yield $200 per unit. He knows that the fixed cost of
$300,000 is irrelevant because it is going to be incurred regardless of whether the order
is accepted or not. Effectively, the additional cost which Company A would have to incur
is the variable cost of $500 per unit. Hence, the order will yield $200 per unit ($700 minus
$500 of variable cost).
Special Order Pricing
Special order pricing is a technique used to calculate the lowest price of a product or
service at which a special order may be accepted and below which a special order should
be rejected. Usually a business receives special orders from customers at a price lower
than normal. In such cases, the business will not accept the special order if it can sell all
its output at normal price. However when sales are low or when there is idle production
capacity, special orders should be accepted if the incremental revenue from special order
is greater than incremental costs.

This method of pricing special orders, in which price is set below normal price but the sale
still generates some contribution per unit, is called contribution approach to special order
pricing. The idea is that it is better to receive something above variable costs, than
receiving nothing at all.

The following example is used to illustrate special order pricing:

Example
A company is producing, on average, 10,000 units of product A per month despite having
30% more capacity. Costs per unit of product A are as follows:

Direct Material $8.00

Direct Labor 5.00
Variable Factory Overhead 2.00
Variable Selling Expense 0.50
Fixed Factory Overhead 3.00
Fixed Office Expense 2.00
$20.50
The company received a special order of 2,000 units of product A at $17.00 per unit from
a new customer. Should the company accept the special order, provided that the
customer has agreed to pay the variable selling expenses in addition to the price of the
product?
Solution

The increment cost per unit for the special order is calculated as:

Direct Material $8.00

Direct Labor 5.00
Variable Factory Overhead 2.00
$15.00
Since the incremental cost per unit is less that the price offered in the special order, the
company should accept it. Accepting special order will generate additional contribution
of $2.00 unit and $4,000 in total.

Make-or-Buy Decision
Make-or-Buy decision (also called the outsourcing decision) is a judgment made by
management whether to make a component internally or buy it from the market. While
making the decision, both qualitative and quantitate factors must be considered.

Examples of the qualitative factors in make-or-buy decision are: control over quality of
the component, reliability of suppliers, impact of the decision on suppliers and customers,
etc.

The quantitative factors are actually the incremental costs resulting from making or
buying the component. For example: incremental production cost per unit, purchase cost
per unit, production capacity available to manufacture the component, etc.

The following example illustrates the numerical part of a simple make-or-buy decision.

Example
The estimated costs of producing 6,000 units of a component are:

Per Unit Total

Direct Material $10 $60,000
Direct Labor 8 48,000
Applied Variable Factory Overhead 9 54,000
Applied Fixed Factory Overhead 12 72,000
$1.5 per direct labor dollar
$39 $234,000
The same component can be purchased from market at a price of $29 per unit. If the
component is purchased from market, 25% of the fixed factory overhead will be saved.

Should the component be purchased from the market?

Solution

Per Unit Total

Make Buy Make Buy
Purchase Price $29 $174,000
Direct Material $10 $60,000
Direct Labor 8 48,000
Variable Overhead 9 54,000
Relevant Fixed Overhead 3 18,000
Total Relevant Costs $30 $29 $180,000 $174,000
Difference in Favor of Buying $1 $6,000

Sell-or-Process-Further Decision
A decision whether to sell a joint product at split-off point or to process it further and sell
it in a more refined form is called a sell-or-process-further decision. Joint products are
two or more products which have been manufactured from the same inputs and in a same
production process (i.e. a joint process). The point at which joint products leave the joint
process is called split-off point.

Some of the joint products may be in final form ready for sale, while others may be
processed further. In such cases managers have to decide whether to sell the unfinished
goods at split-off point or to process them further. Such decision is known as sell-or-
process-further decision and it must be made so as to maximize the profits of the
business.

A sell-or-process-further analysis can be carried out in three different ways:

 Incremental (or Differential) Approach calculates the difference between the

additional revenues and the additional costs of further processing. If the difference
is positive the product must be processed further, otherwise not.
  Opportunity Cost Approach calculates the difference between net revenue from
further processed product and the opportunity cost of not selling the product at
split-off point. If the difference is positive, further processing will increase profits.
 Total Project Approach (or the comparative statement approach) compares the
profit statements of both options (i.e. selling or further processing) separately for
each product. The option generating higher profit is chosen.

The following example illustrates the approaches to a sell-or-process-further decision:

Example
Product A and B are produced in a joint process. At split-off point, Product A is complete
whereas product B can be process further. The following additional information is
available:

Product A B
Quantity in Units 5,000 10,000
Selling Price Per Unit:
At Split-Off $10 $2.5
If Processed Further $5
Costs After Split-Off $20,000
Perform sell-or-process-further analysis for product B.

Solution

Incremental Approach:

Incremental Revenue $25,000

Incremental Costs 20,000
Increase in Profits Due to Further Processing $5,000
Opportunity Cost Approach:

Sales in Case of Further Processing $50,000

Costs:
Additional Costs 20,000
Opportunity Cost of Not Selling at Split-Off 25,000
Gain on Further Processing $5,000
Total Project Approach:

Split-Off Further
Point Processed
Revenue $25,000 $50,000
Costs 0 20,000
Net Revenue $25,000 $30,000
Gain from Further Processing $5,000

Decision to Add or Drop Product Line

A decision whether or not to continue an old product line or department, or to start a
new one is called an add-or-drop decision. An add-or-drop decision must be based only
on relevant information.
Relevant information includes the revenues and costs which are directly related to a
product line or department. Examples of relevant information are sales revenue, direct
costs, variable overhead and direct fixed overhead. Such decision must not be based on
irrelevant information such as allocated fixed overhead because allocated fixed overhead
will not be eliminated if the product line or department is dropped.

The following example illustrates an add-or-drop decision:

Example
A company has three products: Product A, Product B and Product C. Income statements
of the three product lines for the latest month are given below:

Product Line A B C
Sales $467,000 $314,000 $598,000
Variable Costs 241,000 169,000 321,000
Contribution Margin $226,000 $145,000 $277,000
Direct Fixed Costs 91,000 86,000 112,000
Apportioned Fixed Costs 93,000 62,000 120,000
Net Income $42,000 − $3,000 $45,000
Use the incremental approach to determine if Product B should be dropped.
Solution

By dropping Product B, the company will lose the sale revenue from the product line. The
company will also obtain gains in the form of avoided costs. But it can avoid only the
variable costs and direct fixed costs of product B and not the allocated fixed costs. Hence:

If Product B is Dropped
Gains:
Variable Costs Avoided $169,000
Direct Fixed Costs Avoided $86,000 $255,000
Less: Sales Revenue Lost $314,000
Decrease in Net Income of the Company $59,000

Assignment:
Differentiate between relevant and irrelevant cost with example
Differentiate avoidable and unavoidable cost with example
Differentiate between relevant and avoidable cost with example