Differential Analysis: The Key to

Decision Making
Chapter 11
Learning Objective 1

Identify relevant and

irrelevant costs and
benefits in a decision.
Relevant Costs and Benefits

A relevant cost is a cost that differs

between alternatives.

A relevant benefit is a benefit that

differs between alternatives.

2
1
Identifying Relevant Costs
An avoidable cost is a cost that can be
eliminated, in whole or in part, by
choosing one alternative over another.
Avoidable costs are relevant costs.
Unavoidable costs are irrelevant costs.

Two broad categories of costs are never

relevant in any decision. They include:
1. Sunk costs.
2. A future cost that does 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.
Different Costs for Different
Purposes
Costs that are
relevant in one
decision situation
may not be relevant
in another context.
Thus, in each
decision situation,
the manager must
examine the data at
hand and isolate the
relevant costs.
 Identifying Relevant Costs
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:

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

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

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

The cost of the The annual cost of

car is a sunk cost insurance is not
and is not relevant. It will remain
relevant to the the same if she
current decision. drives or takes the
train.
However, the cost of gasoline is clearly relevant if she
decides to drive. If she takes the train, the cost would
not be incurred, so it varies depending on the decision.
 Identifying Relevant Costs
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.
Identifying Relevant Costs
Which costs and benefits are relevant in Cynthia’s
decision?

The decline in resale The round-trip train

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

Relaxing on the train is The kennel cost is not

relevant even though relevant because
it is difficult to assign Cynthia will incur the
a dollar value to the cost if she drives or
benefit. takes the train.
Identifying Relevant Costs
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.
Identifying Relevant Costs
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.
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:
 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.

We can efficiently analyze the decision by

looking at the different costs and revenues
and arrive at the same solution.
 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.
Learning Objective 2

Prepare an analysis
showing whether a
product line or other
business segment should
be added or dropped.
 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 To assess this
hinge primarily on the impact, it is
impact the decision will necessary
have on net operating to
income. carefully analyze
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.
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 to the
costs that would be avoided if the
line was to be dropped.
Adding/Dropping Segments
Adding/Dropping Segments

An investigation has revealed that the fixed

general factory overhead and fixed general
administrative expenses will not be affected by
dropping the digital watch line. The fixed general
factory overhead and general administrative
expenses assigned to this product would be
reallocated to other product lines.
Adding/Dropping Segments

The equipment used to manufacture

digital watches has no resale
value or alternative use.

Should Lovell retain or drop

the digital watch segment?
A Contribution Margin Approach

Re
t ai
n
 Comparative Income Approach

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.
 If the digital watch
line is dropped, the
company loses
$300,000 in
contribution margin.
On the other hand, the general
factory overhead would be
the same under both
alternatives, so it is
irrelevant.
The salary of the product line
manager would disappear,
so it is relevant to the
decision.
 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.
 The complete comparative
income statements reveal that
Lovell would earn $40,000 of
additional profit by retaining the
digital watch line.
Beware of Allocated Fixed Costs
Why should we keep the
digital watch segment
when it’s showing a
$100,000 loss?
Beware of Allocated Fixed Costs

The answer lies in the

way we allocate
common fixed costs
to our products.
 Beware of Allocated Fixed Costs

Including unavoidable Our allocations can

common fixed costs make a segment
makes the product line look less profitable
appear to be unprofitable. than it really is.
Learning Objective 3

Prepare a make or buy

analysis.
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.
Vertical Integration- Advantages

Smoother flow of
parts and materials

Better quality
control

Realize profits
 Vertical Integration- Disadvantage
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.
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:
The Make or Buy Decision
• 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 we accept the supplier’s offer?
The Make or Buy Decision

The avoidable costs associated with making part 4A include direct

materials, direct labor, variable overhead, and the supervisor’s salary.
The Make or Buy Decision

The depreciation of the special equipment represents a sunk

cost. The equipment has no resale value, thus its cost and
associated depreciation are irrelevant to the decision.
The Make or Buy Decision

Not avoidable; irrelevant. If the product is

dropped, it will be reallocated to other products.
The Make or Buy Decision

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

How would this concept potentially relate

to the Essex Company?
Learning Objective 4

Prepare an analysis
showing whether a
special order should be
accepted.
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.
 Special Orders
➢ 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?

Special Orders

$8 variable cost
 Special Orders
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.

Note: This answer assumes that the fixed costs are

unavoidable and that variable marketing costs must be
incurred on the special order.
Quick Check ✓
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)
Quick Check ✓
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
Quick Check ✓
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
imprint ing machine
Variable has no further
production costuse after this
$100,000
order. Additional fixed cost + 50,000
a. $50 Total relevant cost $150,000
b. $10 Number of units 10,000
c. $15 Average cost per unit= $15
d. $29
Learning Objective 5

Determine the most

profitable use of a
constrained resource.
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.
 Utilization of a Constrained
Resource
• Fixed costs are usually unaffected in these
situations, so the product mix that maximizes
the company’s total contribution margin should
ordinarily be selected.
• A company should not necessarily promote those
products that have the highest unit contribution
margins.
• Rather, total contribution margin will be
maximized by promoting those products or
accepting those orders that provide the highest
contribution margin in relation to the
constraining resource.
Ensign Company produces two products and
selected data are shown below:
 Utilization of a Constrained
Resource: An Example
• Machine A1 is the constrained resource
and is being used at 100% of its capacity.
• There is excess capacity on all other
machines.
• Machine A1 has a capacity of 2,400
minutes per week.

Should Ensign focus its efforts on

Product 1 or Product 2?
Quick Check ✓
How many units of each product can be
processed through Machine A1 in one
minute?

Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit
Quick Check ✓
How many units of each product can be
processed through Machine A1 in one
minute?
Product 1 Product 2
a. 1 unit 0.5 unit
b. 1 unit 2.0 units
c. 2 units 1.0 unit
d. 2 units 0.5 unit
Just checking to make sure you are with us.
Quick Check ✓
What generates more profit for the company,
using one minute of machine A1 to process
Product 1 or using one minute of machine A1 to
process Product 2?
a. Product 1
b. Product 2
c. They both would generate the same profit.
d. Cannot be determined.
Quick Check ✓
What generates more profit for the company,
using one minute of machine A1 to process
Product 1 or using one minute of machine A1 to
process Product 2?
a. Product 1
b. Product 2
With both
c. They one minute of machine
would generate theA1, Ensign
same could
profit.
make 1 unit of Product 1, with a contribution
d. Cannot be determined.
margin of $24, or 2 units of Product 2, each with a
contribution margin of $15 per unit.

2 × $15 = $30 > $24

 Utilization of a Constrained
Resource
The key is the contribution margin per unit of the
constrained resource.

Ensign should emphasize Product 2 because it

generates a contribution margin of $30 per minute
of the constrained resource relative to $24 per
minute for Product 1.
 Utilization of a Constrained
Resource
The key is the contribution margin per unit of the
constrained resource.

Ensign can maximize its contribution margin

by first producing Product 2 to meet customer
demand and then using any remaining
capacity to produce Product 1. The
calculations would be performed as follows.
Utilization of a Constrained Resource
Let’s see how this plan would work.
Utilization of a Constrained Resource
Let’s see how this plan would work.
Utilization of a Constrained Resource
Let’s see how this plan would work.
 Utilization of a Constrained
Resource
According to the plan, we will produce
2,200 units of Product 2 and 1,300
of
Product 1. Our contribution margin
looks like this.

The total contribution margin for Ensign is $64,200.

Learning Objective 6

Determine the value of

obtaining more of the
constrained resource.
Value of a Constrained Resource
Increasing the capacity
of a constrained
resource should lead to
increased production
and sales.

How much should

Ensign be willing to pay
for an additional
minute of A1 machine
time?
Value of a Constrained Resource
The additional machine time would be
used to make more units of Product 1,
which had a contribution margin per
minute of $24.

Ensign should be willing to pay up to $24

per minute. This amount equals the
contribution margin per minute of machine
time that would be eared producing more
units of Product 1.
Quick Check ✓
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.

The company’s supplier of hardwood will only

be able to supply 2,000 board feet this month. Is
this enough hardwood to satisfy demand?
a. Yes
b. No
Quick Check ✓
Colonial Heritage makes reproduction colonial
furniture from select hardwoods.

The company’s supplier of hardwood will only

be able to supply 2,000 board feet this month. Is
this enough hardwood to satisfy demand?
a. Yes
b. No
(2 × 600) + (10 × 100 ) = 2,200 > 2,000
Quick Check ✓

The company’s supplier of hardwood will

only be able to supply 2,000 board feet this
month. What plan would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
Quick Check ✓

The company’s supplier of hardwood will

only be able to supply 2,000 board feet this
month. What plan would maximize profits?
a. 500 chairs and 100 tables
b. 600 chairs and 80 tables
c. 500 chairs and 80 tables
d. 600 chairs and 100 tables
Quick Check ✓
As before, Colonial Heritage’s supplier of
hardwood will only be able to supply 2,000
board feet this month. Assume the company
follows the plan we have proposed. Up to how
much should Colonial Heritage be willing to pay
above the usual price to obtain more hardwood?
a. $40 per board foot
b. $25 per board foot
c. $20 per board foot
d. Zero
Quick Check ✓
The additional wood would be used to make
tables. In this use, each board foot of
•As before,wood
additional Colonial Heritage’s
will allow thesupplier of
company to earn
an• additional
hardwood will$20
onlyofbe contribution margin
able to supply 2,000 board and
feet this month. Assume the company follows the
profit.
plan we have proposed. Up to how much should
a. $40 per board foot
Colonial Heritage be willing to pay above the usual
b. $25
priceper board
to obtain foot
more hardwood?
c. $20 per board foot
d. Zero
 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.
Learning Objective 7

Prepare an analysis
showing whether joint
products should be sold
at the split-off point or
processed further.
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 products.
• The point in the manufacturing process
where each joint product can be
recognized as a separate product is called
the split-off point.
Joint Products
For example,
Oil in the petroleum
refining industry,
a large number
Common of products are
Joint
Production Gasoline extracted from
Process crude oil,
Input
including
gasoline, jet fuel,
Chemicals
home heating
oil, lubricants,
asphalt, and
Split-Off various organic
Point chemicals.
Joint Products
Joint costs
are incurred
up to the Oil
Separate Final
split-off point Processing Sale

Common
Joint Final
Production Gasoline
Process
Input Sale

Separate Final
Chemicals
Processing
Sale

Split-Off Separate
Point
Product
The Pitfalls of Allocation
Joint costs are traditionally
allocated among different
products at the split-off point.
A typical approach is to allocate
joint costs according to the
relative sales value of the end
products.
Although allocation is needed
for some purposes such as
balance sheet inventory
valuation, allocations of this
kind are very dangerous for
 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.
 Sell or Process Further: An
Example
• Sawmill, Inc. cuts logs from which unfinished
lumber and sawdust are the immediate joint
products.
• Unfinished lumber is sold “as is” or processed
further into finished lumber.
• Sawdust can also be sold “as is” to gardening
wholesalers or processed further into “presto-
logs.”
Sell or Process Further
Data about Sawmill’s joint products includes:
Sell or Process Further
Sell or Process Further
Sell or Process Further

The lumber should be processed

further and the sawdust should be
sold at the split-off point.
 Activity-Based Costing and
ABC can be usedRelevant Costs
to help identify potentially relevant
costs for decision-making purposes.

However, managers should

exercise caution against reading
more into this “traceability”
than really exists.

People have a tendency to assume that if a cost is traceable to a

segment, then the cost is automatically avoidable, which is untrue.
Before making a decision, managers must decide which of the
potentially relevant costs are actually avoidable.
End of Chapter 11

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