12-1

Differential Analysis
The Key to Decision Making
 12-2

Relevant Costs and Benefits

A relevant cost is a cost that differs
between alternatives.

A relevant benefit is a benefit that differs

between alternatives.
 12-3

Identifying Relevant Costs

An
An avoidable
avoidable cost
cost is
is aa cost
cost that
that can
can be
be eliminated,
eliminated, inin whole
whole or
or in
in part,
part, by
by
choosing
choosing one
one alternative
alternative over
over another.
another. Avoidable
Avoidable costs
costs are
are relevant
relevant costs.
costs.
Unavoidable
Unavoidable costs
costs are
are irrelevant
irrelevant costs.
costs.

Two broad categories of costs are never

relevant in any decision. They include:
Sunk costs.
A future cost that does not differ between
the alternatives.
 12-4

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.
 12-5

Total and Differential Cost Approaches

The management of a company is considering a new labor saving
machine that rents for $3,000 per year. Data about the company’s
annual sales and costs with and without the new machine are:
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
Direct materials (5,000 units @ $14 per unit) 70,000 70,000 -
Direct labor (5,000 units @ $8 and $5 per unit) 40,000 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses 120,000 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:
Other 62,000 62,000 -
Rent on new machine - 3,000 (3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000
 12-6

Total and Differential Cost Approaches

As you can see, the only costs that differ between the
alternatives are the direct labor costs savings and the
increase in fixed rental costs.
Situation Differential
Current With New Costs and
Situation Machine Benefits
Sales (5,000 units @ $40 per unit) $ 200,000 $ 200,000 -
Less variable expenses:
We
Direct materials canunits
(5,000 efficiently analyze the
@ $14 per unit) decision 70,000
70,000 by -
Direct labor (5,000 units @ $8 and $5 per unit)
looking at the different costs 40,000 and revenues 25,000 15,000
Variable overhead (5,000 units @ $2 per unit) 10,000 10,000 -
Total variable expenses and arrive at the same 120,000 .
solution 105,000 -
Contribution margin 80,000 95,000 15,000
Less fixed expense:Net Advantage to Renting the New Machine
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Other 62,000 62,000 -
Increase in fixed rental expenses (3,000)
Rent on newNet machine
annual cost saving from renting the new machine
- $
3,000
12,000
(3,000)
Total fixed expenses 62,000 65,000 (3,000)
Net operating income $ 18,000 $ 30,000 12,000
 12-7

Adding/Dropping Segments
One of the most important
decisions managers make is
whether to add or drop a
business segment. Ultimately, a
decision to drop an old segment
or add a new one is going to
hinge primarily on the impact
the decision will have on net
operating income. To assess this impact, it
is necessary to carefully
analyze the costs.
 12-8

Adding/Dropping Segments

Due to the declining popularity of digital

watches, Lovell Company’s digital watch line
has not reported a profit for several years.
Lovell is considering discontinuing this
product line.
 12-9

Adding/Dropping Segments
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
Variable shipping costs 5,000
Commissions 75,000 200,000
Contribution margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - direct 100,000
Rent - factory space 70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
 12-10

A Contribution Margin
Approach Contribution Margin
Solution
Contribution margin lost if digital
watches are dropped $ (300,000)
Less fixed costs that can be avoided
Salary of the line manager $ 90,000
Advertising - direct 100,000
Rent - factory space 70,000 260,000
Net disadvantage $ (40,000)

RRe
ettaai
inn
 12-11

The Make or Buy Decision

When
When aa company
company is is involved
involved in in more
more than
than one
one activity
activity in
in the
the entire
entire value
value
chain,
chain, itit is
is vertically
vertically integrated.
integrated. A A decision
decision to
to carry
carry out
out one
one of
of the
the
activities
activities in
in the
the value
value chain
chain internally,
internally, rather
rather than
than to
to buy
buy externally
externally from
from aa
supplier
supplier is
is called
called aa “make
“make or
or buy”
buy” decision.
decision.
 12-12

The Make or Buy Decision:

An Example
Essex Company manufactures part 4A that is used in one of its products. The
unit product cost of this part is:

Direct materials $ 9
Direct labor 5
Variable overhead 1
Depreciation of special equip. 3
Supervisor's salary 2
General factory overhead 10
Unit product cost $ 30
 12-13

The Make or Buy Decision Cost

Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

The avoidable costs associated with making part 4A include direct

materials, direct labor, variable overhead, and the supervisor’s salary.
 12-14

The Make or Buy Decision Cost

Per
Unit Cost of 20,000 Units
Make Buy
Outside purchase price $ 25 $ 500,000

Direct materials (20,000 units) $ 9 180,000

Direct labor 5 100,000
Variable overhead 1 20,000
Depreciation of equip. 3 -
Supervisor's salary 2 40,000
General factory overhead 10 -
Total cost $ 30 $ 340,000 $ 500,000

Should we make or buy part 4A?

Given that the total avoidable costs are less than the cost of
buying the part, Essex should continue to make the part.
 12-15

Opportunity Cost
An
An opportunity
opportunity cost
cost is
is the
the benefit
benefit that
that is
is foregone
foregone as
as aa result
result of
of pursuing
pursuing
some
some course
course ofof action.
action.
Opportunity
Opportunity costs
costs are
are not
not actual
actual cash
cash outlays
outlays and
and are
are not
not recorded
recorded in
in the
the
formal
formal accounts
accounts of
of an
an organization.
organization.
 12-16

Key Terms and Concepts

A special order is a one-time
order that is not considered
part of the company’s normal
ongoing business.

When analyzing a special

order, only the incremental
costs and benefits are
relevant.
Since the existing fixed
manufacturing overhead costs
would not be affected by the
order, they are not relevant.
 12-17

Key Terms and Concepts

When a limited resource of
some type restricts the
company’s ability to satisfy
demand, the company is
said to have a constraint.

The machine or
process that is
limiting overall output
is called the
bottleneck – it is the
constraint.
 12-18

Joint Costs
In some industries, a number of end products
are produced from a single raw material input.
Two or more products produced from a
common input are called joint
joint products.
products
The point in the manufacturing process where
each joint product can be recognized as a
separate product is called the split-off
split-off point.
point
 12-19

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.