Differential Analysis: The

Key to Decision Making

CHAPTER 8

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

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8-2

Learning Objective 1

Identify relevant and

irrelevant costs and benefits
in a decision.

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8-3

Decision Making – Six Key Concepts –

Concepts 1 and 2
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 benefits should be considered
when making decisions.
• Irrelevant costs and irrelevant benefits should be ignored
when making decisions.
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8-4

Decision Making – Six Key Concepts –

Concept 3
Key Concept #3
The key to effective decision making is differential analysis—
focusing on the future costs and benefits 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.
•Future revenue that differs between any two alternatives is
known as 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.

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8-5

Decision Making – Six Key Concepts –

Concepts 4 and 5
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 benefits that do not differ between
alternatives are irrelevant to the decision-making process.

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 12-6
8-6

Decision Making – Six Key Concepts –

Concept 6
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.

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8-7

Identifying Relevant Costs – An Example

Cynthia, a Boston student, is considering visiting her friend in New York. She
can drive or take the train. By car, it is 230 miles to her friend’s apartment. She
is trying to decide which alternative is less expensive and has gathered the
following information.

Automobile Costs (based on 10,000 miles driven per year)

Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

$45 per month × 8 months $2.70 per gallon ÷ 27 MPG

$24,000 cost – $10,000 salvage value ÷ 5 years

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8-8

Identifying Relevant Costs – Additional

Information
Automobile Costs (based on 10,000 miles driven per year)
Annual Cost Cost per
of Fixed Items Mile
1 Annual straight-line depreciation on car $ 2,800 $ 0.280
2 Cost of gasoline 0.100
3 Annual cost of auto insurance and license 1,380 0.138
4 Maintenance and repairs 0.065
5 Parking fees at school 360 0.036
6 Total average cost $ 0.619

Additional Information
7 Reduction in resale value of car per mile of wear $ 0.026
8 Round-tip train fare $ 104
9 Benefits of relaxing on train trip ????
10 Cost of putting dog in kennel while gone $ 40
11 Benefit of having car in New York ????
12 Hassle of parking car in New York ????
13 Per day cost of parking car in New York $ 25

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8-9

Identifying Relevant Costs – Part 1

Which costs and benefits are relevant in Cynthia’s decision?

The cost of the car is The annual cost of insurance

a sunk cost and is is not relevant. It will remain
not relevant to the the same if she drives or
current decision. takes the train.

However, the cost of gasoline is clearly relevant if she decides

to drive. If she takes the train, she would avoid the cost of the
gasoline, so the cost differs between the alternatives.

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8-10

Identifying Relevant Costs – Part 2

Which costs and benefits are relevant in Cynthia’s
decision?

The cost of The monthly school

maintenance and parking fee is not
repairs is relevant. In relevant because it
the long-run, these must be paid if Cynthia
costs depend upon drives or takes the
miles driven. train.

At this point, we can see that some of the average cost of

$0.619 per mile are relevant and others are not.
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Identifying Relevant Costs – Part 3

Which costs and benefits are relevant in Cynthia’s
decision?

The decline in resale The round-trip train fare

value due to additional is clearly relevant. If she
miles is a relevant cost. drives the cost can be
avoided.

Relaxing on the train is The kennel cost is not

relevant even though it relevant because
is difficult to assign a Cynthia will incur the
dollar value to the cost if she drives or
benefit. takes the train.
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8-12

Identifying Relevant Costs – Part 4

Which costs and benefits are relevant in Cynthia’s
decision?

The cost of parking in

New York is relevant
because it can be
avoided if she takes
the train.

The benefits of having a car in New York and

the problems of finding a parking space are
both relevant but are difficult to assign a
dollar amount.
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Identifying Relevant Costs – Part 5

From a financial standpoint, Cynthia would be better off
taking the train to visit her friend. Some of the non-
financial factors may influence her final decision.

Relevant Financial Cost of Driving

Gasoline (460 @ $0.100 per mile) $ 46,00
Maintenance (460 @ $0.065 per mile) 29,90
Reduction in resale (460 @ $0.026 per mile) 11,96
Parking in New York (2 days @ $25 per day) 50,00
Total $ 137,86

Relevant Financial Cost of Taking the Train

Round-trip ticket $ 104,00

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8-14

Total and Differential Cost Approaches –

Total Cost Approach
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

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8-15

Total and Differential Cost Approaches –

Differential Cost Approach
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:
Direct materials (5,000 units @ $14 per unit) 70.000 70.000 -
We can efficiently analyze the decision by
Direct labor (5,000 units @ $8 and $5 per unit)
Variable overhead (5,000 units @ $2 per unit)
40.000
10.000
25.000
10.000
15.000
-

Contribution margin
looking at the different costs and revenues
Total variable expenses 120.000
80.000
105.000
95.000
-
15.000
Less fixed expense: and arrive at the same solution.
Other 62.000 62.000 -
Rent on new machineFinanical Advantage of Renting the New Machine
- 3.000 (3.000)
Total fixed expenses 62.000 65.000 (3.000)
Decrease in direct labor costs (5,000 units @ $3 per unit) $ 15,000
Net operating income $ 18.000 $ 30.000 12.000
Increase in fixed rental expenses (3,000)
Financial advantage of renting the new machine $ 12,000

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8-16

Total and Differential Cost Approaches

Using the differential approach is desirable for two

reasons:
1. Only rarely will enough information be available to
prepare detailed income statements for both
alternatives.
2. Mingling irrelevant costs with relevant costs may
cause confusion and distract attention away from the
information that is really critical.

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 12-17
8-17

Learning Objective 2

Prepare an analysis showing

whether a product line or
other business segment
should be added or dropped.

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8-18

Adding/Dropping Segments – Part 1

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 To assess this impact, it
hinge primarily on its financial is necessary to carefully
impact. analyze the costs.

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8-19

Adding/Dropping Segments – Part 2

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 whether to keep this
product line or drop it.

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8-20

A Contribution Margin Approach

DECISION RULE
Lovell should drop the digital watch segment
only if its profit would increase.
Lovell will compare the contribution margin
that would be lost if the digital watch line was
discontinued to the fixed expenses that would
be avoided if the line was discontinued.

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8-21

Adding/Dropping Segments – Example –

Part 1
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)
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8-22

Adding/Dropping Segments – Example –

Part 2
Segment Income Statement
Digital Watches
Sales $ 500.000
Less: variable expenses
An investigation
Variable manufacturing has revealed
costs that the fixed
$ 120.000
general
Variable factory
shipping overhead and5.000
costs fixed general
Commissions 75.000 200.000
administrative expenses will not be affected
Contribution margin
by
$ 300.000
dropping
Less: the digital watch line. The fixed general
fixed expenses
factoryfactory
General overhead and general
overhead administrative
$ 60.000
Salary of line manager 90.000
expenses assigned
Depreciation of equipment
to this product
50.000
would be
reallocated
Advertising - direct to other product
100.000lines.
Rent - factory space 70.000
General admin. expenses 30.000 400.000
Net operating loss $ (100.000)
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Adding/Dropping Segments – Example –

Part 3
Segment Income Statement
Digital Watches
Sales $ 500,000
Less: variable expenses
Variable manufacturing costs $ 120,000
The equipment used to manufacture
Variable shipping costs 5,000
digital watches has no resale
Commissions 75,000 200,000
value
Contribution or alternative use.
margin $ 300,000
Less: fixed expenses
General factory overhead $ 60,000
Salary of line manager 90,000
Depreciation of equipment 50,000
Advertising - directShould Lovell retain or drop
100,000
Rent - factory spacethe digital watch segment?
70,000
General admin. expenses 30,000 400,000
Net operating loss $ (100,000)
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Contribution Margin Approach Solution

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

Financial disadvantage of dropping

the digital wataches product line $ (40.000)

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Comparative Income Approach – Part 1

The Lovell solution can also be obtained by

preparing comparative income statements
showing results with and without the digital
watch segment.

Let’s look at this second approach.

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Comparative Income Approach – Part 2

If the digital watch line

is dropped, the
company loses
$300,000 in
contribution margin.
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Comparative Income Approach – Part 3

On the other hand, the general

factory overhead would be the
same under both alternatives, so
it is irrelevant.
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Comparative Income Approach – Part 4 8-28

The salary of the product line

manager would disappear, so it is
relevant to the decision.

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Comparative Income Approach – Part 5

The depreciation is a sunk cost. Also, remember that the

equipment has no resale value or alternative use, so the
equipment and the depreciation expense associated with
it are irrelevant to the decision.

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Comparative Income Approach – Part 6 8-30

The complete comparative

income statements reveal that
Lovell would earn $40,000 of
additional profit by retaining the
digital watch line.

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8-31

Beware of Allocated Fixed Costs – Part 1

Be aware that allocated fixed costs can distort the

keep/drop decision.

Lovell’s managers may ask: “Why

should we keep the digital watch
segment when it’s showing a
$100,000 loss?”

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Beware of Allocated Fixed Costs – Part 2

The answer lies in the way we allocate

common fixed costs to our products.

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Beware of Allocated Fixed Costs – Part 3

Including unavoidable common

fixed costs makes the product
line appear to be unprofitable,
when in fact dropping the
product line would decrease the
company’s overall net operating
income.

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Learning Objective 3

Prepare a make or buy

analysis.

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The Make or Buy Decision

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

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Vertical Integration – Advantages

Smoother flow of
parts and materials

Better quality
control

Realize profits

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Vertical Integration – Disadvantages

Companies may fail to take advantage of
suppliers who can create economies of scale
advantage by pooling demand from numerous
companies.

While the economics of scale factor can be

appealing, a company must be careful to retain
control over activities that are essential to
maintaining its competitive position.

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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

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The Make or Buy Decision – Part 1

The special equipment used to manufacture part 4A has no
resale value.
The total amount of general factory overhead, which is
allocated on the basis of direct labor hours, would be
unaffected by this decision.
The $30 unit product cost is based on 20,000 parts produced
each year.
An outside supplier has offered to provide the 20,000 parts at a
cost of $25 per part.
Should the company stop making part 4A and buy it from an
outside supplier?

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The Make or Buy Decision – Part 2

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
Allocated gen. fact. 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.

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The Make or Buy Decision – Part 3

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
Allocated gen. fact. overhead 10 -
Total cost $ 30 $ 340.000 $ 500.000

The cost incurred to buy the equipment is a sunk cost; the

depreciation simply spreads this sunk cost over the
equipment’s useful life.

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The Make or Buy Decision – Part 4

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
Allocated gen. fact. overhead 10 -
Total cost $ 30 $ 340.000 $ 500.000

The allocated general factory overhead represents allocated costs

common to all items produced in the factory and would continue
unchanged. Thus, it is irrelevant to the decision.
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The Make or Buy Decision – Part 5

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
Allocated gen. fact. overhead 10 -
Total cost $ 30 $ 340.000 $ 500.000
Financial advantage of making part 4A $160,000
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.
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Opportunity Cost

Opportunity costs are not actual cash outlays and are not
recorded in the formal accounts of an organization.
An opportunity cost is the benefit that is foregone as a
result of pursuing some course of action.
If the space to make Part 4A had an alternative use, the
opportunity cost would have been equal to the segment
margin that could have been derived from the best
alternative use of the space.

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Learning Objective 4

Prepare an analysis showing

whether a special order
should be accepted.

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8-46

Special Orders
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.

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Special Orders – Example

 Jet Inc. makes a single product whose normal selling price is
$20 per unit.
 A foreign distributor offers to purchase 3,000 units for $10
per unit.
 This is a one-time order that would not affect the company’s
regular business.
 Annual capacity is 10,000 units, but Jet Inc. is currently
producing and selling only 5,000 units.

Should Jet accept the offer?

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Special Orders – Part 1

Jet Inc.
Contribution Inc. Stmt, before considering special order
Revenue (5,000 × $20) $ 100.000
Variable costs:
Direct materials $ 20.000
Direct labor 5.000
Manufacturing overhead 10.000 $8 variable cost
Marketing costs 5.000
Total variable costs 40.000
Contribution margin 60.000
Fixed costs:
Manufacturing overhead $ 28.000
Marketing costs 20.000
Total fixed costs 48.000
Net operating income $ 12.000
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Special Orders – Part 2

If Jet accepts the special order, the incremental revenue will exceed
the incremental costs. In other words, net operating income will
increase by $6,000. This suggests that Jet should accept the order.

Incremental revenue (3,000 × $10) $ 30.000

Incremental cost (3,000 × $8 variable cost) 24.000

Financial advantage of accepting the order $ 6.000

Note: This answer assumes that the fixed costs are

unavoidable and that variable marketing costs must be
incurred on the special order.
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8-50

Quick Check 1
Northern Optical ordinarily sells the X-lens for $50. The
variable production cost is $10, the fixed production cost is
$18 per unit, and the variable selling cost is $1. A customer
has requested a special order for 10,000 units of the X-lens
to be imprinted with the customer’s logo. This special
order would not involve any selling costs, but Northern
Optical would have to purchase an imprinting machine for
$50,000.
(see the next page)

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Quick Check 1a
What is the rock bottom minimum price below which Northern
Optical should not go in its negotiations with the customer? In
other words, below what price would Northern Optical actually
be losing money on the sale? There is ample idle capacity to
fulfill the order and the imprinting machine has no further use
after this order.
a. $50
b. $10
c. $15
d. $29

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