Differential Analysis: The Key

to Decision Making
 Learning Objectives

• Distinguish between relevant and irrelevant costs

and revenues in (alternative-choice) decisions.
• Prepare analyses showing
– whether to add or drop a segment
– whether to make or buy a component
– whether to accept or reject a special order
– the most profitable use of a scarce resource
– whether to sell or further process a product
Decision Making – Six Key Concepts
Key Concept #1
Every decision involves choosing from among at least two
alternatives. Therefore, the first step in decision-making is
to define the alternatives being considered.

Key Concept #2
Once you have defined the alternatives, you need to
identify the criteria for choosing among them.
• Relevant costs and relevant revenues should be
considered when making decisions.
• Irrelevant costs and irrelevant revenues should be
ignored when making decisions.
Decision Making – Six Key Concepts
Key Concept #3

The key to effective decision making is differential analysis –

focusing on the future costs and revenues that differ between
the alternatives. Everything else is irrelevant and should be
ignored.
• A future cost that differs between any two alternatives is
known as a differential cost.
• A future revenue that differs between any two alternatives is
known as a differential revenue.
• An incremental cost is an increase in cost between two
alternatives.
• An avoidable cost is a cost that can be eliminated by
choosing one alternative over another.
Decision Making – Six Key Concepts

Key Concept #4
Sunk costs are always irrelevant when choosing among
alternatives.
• A sunk cost is a cost that has already been incurred and
cannot be changed regardless of what a manager decides
to do.

Key Concept #5
Future costs and revenues that do not differ between
alternatives are irrelevant to the decision-making process.
Decision Making – Six Key Concepts

Key Concept #6

Opportunity costs also need to be considered when

making decisions.
• An opportunity cost is the potential benefit that is given
up when one alternative is selected over another.
Identifying Relevant Costs – Example
A manager at White Co. wants to replace an old
machine with a new one. What costs are relevant?
New machine:
Cost $ 90,000
Annual variable expenses 80,000
Expected life in years 5
Old machine:
Book value 60,000
Disposal value now 15,000
Annual variable expenses 100,000
Remaining life in years 5
Annual fixed expenses, not dep. $ 70,000
 Identifying Relevant Costs – Example

Purchase
Keep Old New
For Five Years Machine Machine Difference
Variable expenses (500,000) (400,000) 100,000
Other fixed expenses (350,000) (350,000) -
Cost - new (90,000) (90,000)
Book value - old (60,000) (60,000) -
Disposal of old machine 15,000 15,000
Total costs $ (910,000) $ (885,000) $ 25,000
Other fixed expenses are the same; book value of the
old machine is a sunk cost. They are not relevant.
 Types of Alternative-Choice Decisions

• Adding or dropping a product or other segments.

• Making or buying a component (outsourcing).
• Accepting or rejecting a special order.
• Rationing of a scarce resource.
• Sale versus further processing.
• Note: These decisions normally have a relatively
short time horizon.
– Time value of money and taxes are ignored.
 General Steps in the Analysis
• Define the problem/opportunity
• Determine possible alternative actions/solutions
– the obviously unattractive ones are eliminated
• For each alternative, measure the differential
(incremental) revenues, costs, or profit
• Evaluate the alternatives
• Reach a decision
Note: Qualitative information is sometimes more
important than differential revenues and expenses.
 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 should be based only on
the differential (incremental) revenues and costs.
Revenue and cost items unaffected by the decision
should be disregarded.
• Differential revenues and costs are segment
contribution margin and some traceable fixed costs.
Note: Qualitative considerations are important.
 Adding or Dropping a Segment Example

• White Company is considering dropping its digital

watch segment.
• The CM of the segment is $300,000.
• Dropping the segment will yield the following fixed
cost savings:
Salary of the division manager $ 90,000
Direct advertising 100,000
Rent for factory space 70,000
• Should White dispose of its digital watch segment?
 Adding or Dropping a Segment
Fixed costs reduction 260,000
Contribution margin lost if digital
watch segment is dropped $ (300,000)
Net disadvantage $ (40,000)

White should not drop its digital watch segment

because its fixed cost savings does not exceed lost
contribution margin.

• This same answer can be reached by preparing

income statements with and without the segment.
• What if the released resources can be used for ...?
 Making or Buying a Component
• Should we outsource a component that we are
currently making? Should we make a component
that we are currently outsourcing?
– Dependability, quality consideration, and focus
are important considerations.
• A make or buy decision should be based only on
the differential (incremental) costs. Cost items
unaffected by the decision should be disregarded.
• The cost of the buy alternative is usually easy to
estimate. The more difficult problem is to find the
differential costs of the make alternative.
 Making or Buying a Component Example
• El Cerrito incurs the following cost for part No. 300:
Total (10,000) Per unit
Direct materials $80,000 $8
Direct labor 10,000 1
Variable overhead (OH) 40,000 4
Fixed OH (traceable) 20,000 2
Fixed OH (Common) 30,000 3
• Another company offers to sell El Cerrito the same
part for $16 per unit. There are no alternative uses of
the capacity that becomes available.
• Should El Cerrito continue to make or buy the part?
 Making or Buying a Component Example
• Items of differential costs are as follows:
If part No. 300
is manufactured
Direct material $8
Direct labor 1
Variable OH 4
Fixed OH (part 300) 2
Total 15
• Based on financial consideration alone, El Cerrito
should continue to make the part.
• What if the released facility can be used for ...?
 Special Orders

• Should we accept a one-time order at a price

below the regular selling price (i.e., an off-price
order)?
• If there are no effects on the operations (e.g., the
market is not spoiled), the order should be
accepted if the differential revenues obtained
exceed differential costs. Revenue and cost items
unaffected by the decision should be disregarded.
 Special Orders Example
• Arlington Brewing Company operates a brewery with
a monthly capacity of one million barrels of a beer
product (Champion) that has gained significant
market share. Current production and sales are
600,000 barrels a month. The selling price is $90 per
barrel. The costs are as follows:
VC /barrel FC /barrel
Direct material (barley, etc.) $ 7
Direct labor 22
Overhead 6 $13
Marketing costs* 5 16
Distribution costs 9 8
* Variable marketing cost is sales commission.
 Special Orders Example

• A Canadian brewery wants to buy 250,000 barrels

of Champion for each of the next four months until
its current brewery is renovated. It is willing to pay
$45 per barrel. If Arlington accepts this order, an
additional $300,000 in manufacturing costs will be
incurred each month. No additional costs will be
incurred for marketing & distribution.
• Should Arlington accept the special order?
 Special Orders Example

• Items of differential monthly revenues and costs are:

Total revenue $11,250,000
Variable costs $8,750,000
Additional costs 300,000 9,050,000
Differential profit $ 2,200,000
• Based on profit alone, Arlington should accept the
offer.
 Rationing A Scarce Resource
• Usually, fixed costs are not affected by this
decision.
• Therefore, producing products with highest
CM per unit of scarce resource maximizes
total contribution margin and overall profit.
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
 Managing Constraints

It is often possible for a manager to increase the capacity of a

bottleneck, which is called relaxing (or elevating) the constraint,
in numerous ways such as:
1. Working overtime on the bottleneck
2. Subcontracting some of the processing that would be done
at the bottleneck
3. Investing in additional machines at the bottleneck
4. Shifting workers from non-bottleneck processes to the
bottleneck
5. Focusing business process improvement efforts on the
bottleneck
6. Reducing defective units processed through the bottleneck
 Sale Versus Further Processing

• Should we sell our product at some point before

the final step in its production?
• Costs incurred prior to the point of decision are
not relevant in deciding whether to sell or further
process a product (joint or otherwise).
• As a general rule, a product should be further
processed if the incremental revenues from
processing it exceed the incremental processing
costs.
 Sensitivity analysis
• All decisions involve making assumptions and
estimates about the future. It is important to make
note of the assumptions and estimates.
• After completing the analysis, it is often useful to
redo the analysis under different assumptions and
estimates to determine the sensitivity of the
conclusions.
• With computer, the sensitivity (what if) analysis
can be performed quickly.