Chapter 12 Differential Analysis STD

Managerial Accounting
Chapter 12:
Differential Analysis
Instructor:
Xiomara Vázquez-Guillén, Ph.D
Managerial Accounting Chapter 12 1

Chapter 12: Differential Analysis:
The Key to Decision Making
Learning Objectives:
1. Identify relevant and irrelevant costs and benefits in a decision
situation.
2. Prepare an analysis showing whether a product line or other
organizational segment should be added or dropped.
3. Prepare a make or buy analysis.
4. Prepare an analysis showing whether a special order should be
accepted.
5. Determine the most profitable use of a constrained resource.
6. Determine the value of obtaining more of the constrained resource.
7. Prepare an analysis showing whether joint products should be sold
at the split-off point or processed further.

Cost Concepts for Decision
Making
A relevant cost is a cost that differs between
alternatives. Relevant costs are avoidable – the cost
will be eliminated in whole or in part by choosing one
alternative over another.
 Unavoidable costs are never relevant:

 Sunk costs.
 Future costs that do not differ between the
alternatives.

Decision Making: A Two-Step
Process
Step 1 Eliminate costs and benefits that do not differ
between alternatives.
Step 2 Use the remaining costs and benefits that differ
between alternatives in making the decision. The
costs that remain are the differential, or avoidable,
costs.
Note: Costs that are relevant in one decision

situation are not necessarily relevant in
another. In each decision situation the
manager must examine the data at hand and
isolate the relevant costs.
Opportunity Cost
 The benefits that are foregone as a result of
pursuing some course of action.
 Opportunity costs are not actual dollar outlays

and are not recorded in the accounts of an
organization.

I. Adding/Dropping Segments
 A decision to drop an old DECISION RULE
segment or add a new one is
going to hinge primarily on the
When: Lost Contribution Margin
impact the decision will have
> Fixed Cost Avoided 
on net operating income. Keep Segment
 To assess this impact, it is

necessary to carefully analyze
When: Lost Contribution Margin
the costs.
< Fixed Cost Avoided 
Drop Segment

II. Make or Buy
 When a company is involved in more than DECISION RULE
one activity in the entire value chain, it is
vertically integrated. A decision to carry
out one of the activities in the value chain Choose the
internally, rather than to buy externally cheapest
from a supplier is called a “make or buy” option!
decision.
(Relevant cost)
 The basic make-or-buy question is whether
a company should make its own parts to
be used in its products or buy them from
outside vendors.

Vertical Integration-
Advantages Disadvantages
Fail to take advantage of suppliers
Smoother flow of
who can create economies of scale
parts and materials
advantage by pooling demand from
numerous companies.
Better quality control

While the economics of scale factor
can be appealing, a company must be
careful to retain control over activities
Realize profits that are essential to maintaining its
competitive position.

III. Accept An Order At A Special Price
 A special order is a one-time order DECISION RULE
that is not considered part of the
company’s normal ongoing business.
Incremental Contribution
 When analyzing a special order, only Margin > Incremental
the incremental costs and benefits Fixed Cost
are relevant.
 Accept the order
 Since the existing fixed
manufacturing overhead costs would
not be affected by the order, they
are not relevant.

IV. Constrained Resource
 When a limited resource of DECISION RULE
some type restricts the
company’s ability to satisfy
Allocate the constraint
demand, the company is said
resource to 
to have a constraint.
Highest contribution
 The machine or process that is margin per the
limiting overall output is called constrained product.
the bottleneck – it is the
constraint.

Managing Constraints
Firms often face the problem of deciding how to best
utilize a constrained resource.
 Usually fixed costs are not affected by this particular
decision, so management can focus on maximizing total

contribution margin.
 A company should not necessarily promote those products
that have the highest unit contribution margins.

 Management should produce the product with the highest
contribution margin per the constrained resource.

V. Joint Costs
 In some industries, a number of DECISION RULE
end products are produced from a
single raw material input.
 Two or more products produced Process further 
from a common input are called Incremental revenue
joint products. processing >
 The point in the manufacturing Incremental
process where each joint product processing costs
can be recognized as a separate
product is called the split-off
point.
Joint Products
Joint costs
are incurred
up to the Oil
Separate Final
split-off point Processing Sale
Common
Joint Final
Production Gasoline
Input Sale
Process
Separate Final
Chemicals
Processing
Sale
Split-Off Separate
Point Product
Chapter 12
Costs 13
Sell or Process Further
Joint costs are irrelevant in decisions regarding what to
do with a product from the split-off point forward.
Therefore, these costs should not be allocated to end
products for decision-making purposes.
With respect to sell or process further decisions, it is

profitable to continue processing a joint product after
the split-off point so long as the incremental revenue
from such processing exceeds the incremental
processing costs incurred after the split-off point.
Reference
 Garrison, Noreen & Brewer
 Managerial Accounting
 15th Edition.

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Managerial Accounting

Managerial Accounting Chapter 12 1

Managerial Accounting Chapter 12 2

 Unavoidable costs are never relevant:

 Future costs that do not differ between the

Managerial Accounting Chapter 12 3

Note: Costs that are relevant in one decision

 Opportunity costs are not actual dollar outlays

Managerial Accounting Chapter 12 5

 To assess this impact, it is

Managerial Accounting Chapter 12 6

Managerial Accounting Chapter 12 7

Better quality control

Managerial Accounting Chapter 12 8

Managerial Accounting Chapter 12 9

Managerial Accounting Chapter 12 10

decision, so management can focus on maximizing total

that have the highest unit contribution margins.

contribution margin per the constrained resource.

Managerial Accounting Chapter 12 11

With respect to sell or process further decisions, it is

Managerial Accounting Chapter 12 15

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