Differential

Analysis: The Key

to Decision Making
GROU
P1
SANTIAGO, KATHLENN P.
TUMADA, MAY ANN T.
UMALI, CRISHELYN T.
UYANGURIN, JOEVANIE C.

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.
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:
Sunk costs.
A future cost that does not differ between the alternatives.

Keys to Successful Decision-Making

1

Focus only on relevant costs (also called avoidable costs, differential costs, or
incremental costs) and relevant benefits (also called differential benefits or
incremental benefits).

Ignore everything else including sunk costs and future costs and benefits that
do not differ between the alternatives.
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 friends apartment. She
is trying to decide which alternative is less expensive and has gathered the
following information:

1
2
3
4

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

Annual Cost
of Fixed
Cost per
Items
Mile
Annual straight-line depreciation on car
P
2,800
P
0.280
Cost of gasoline
0.100
Annual cost of auto insurance and license
1,380
0.138
Maintenance and repairs
0.065

Parking fees at school

360

0.036

Total average cost

0.619

Some Additional Information

7

Reduction in resale value of car per mile of wear

P 0.026

Round-tip train fare

Benefits of relaxing on train trip

1
0

Cost of putting dog in kennel while gone

11

Benefit of having car in New York

????

1
2

Hassle of parking car in New York

????

1
3

Per day cost of parking car in New York

104
????

40

25

She has also gathered additional information to aid in her decision,

such as the reduction in resale value per mile driven, round-trip train fare,
benefits of relaxing on the train, cost of putting her dog in the kennel,
benefits of having a car in New York, hassle of parking in New York, and the
per day cost of parking in New York. Some of these items can be measured in
dollars and some cant.
Which costs and benefits are relevant in Cynthias decision?
The cost of the car is a sunk cost and is not relevant to the current
decision.
The annual cost of insurance is not relevant. It will remain the same if
she 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.
Which costs and benefits are relevant in Cynthias decision?
The cost of maintenance and repairs is relevant because in the long-run
these costs depend upon miles driven.
The parking fee at school is irrelevant because it is not a differential cost.
At this point, we can see that some of the average cost of P0.619 per mile are
relevant and others are not.
Which costs and benefits are relevant in Cynthias decision?
The decline in resale value is relevant due to the additional miles driven.

The round-trip train fare is relevant because it is avoidable if she drives

her car.
Relaxing on the train is relevant, but difficult to quantify.
The kennel cost is irrelevant because it is not a differential cost.
Which costs and benefits are relevant in Cynthias decision?
The cost of parking in New York is relevant because it is avoidable if she
takes the train.
The benefits of having a car in New York and the problem of finding a
parking space are both relevant, but difficult to quantify.
From a financial standpoint, Cynthia would be better off taking the train. But,
as with any decision we may face, it may be the nonfinancial or
nonquantitative factors that have the most impact on our decision.
Relevant Financial Cost of Driving
Gasoline (460 @ P0.100 per mile)

46.00

Maintenance (460 @ P0.065 per mile)

29.90
Reduction in resale (460 @ P0.026 per mile)
11.96
Parking in New York (2 days @ P25 per day)
50.00
Total
P 137.86
Relevant Financial Cost of Taking the Train
Round-trip ticket
P 104.00

Total and Differential Cost Approaches

The management of a company is considering a new labor-saving
machine that rents for P3,000 per year. Data about the companys annual
sales and costs with and without the new machine are:
Less variable expenses:
Direct materials (5,000 units @ P14 per unit)
Direct labor (5,000 units @ P8 and P5 per unit)
Variable overhead (5,000 units @ P2 per unit)
Total variable expenses
Contribution margin
Less fixed expense:
Other
Rent on new machine

70,000

40,000
10,000
120,000

25,000
10,000
105,000

15,000

80,000

95,000

15,000

62,000

62,000

Total fixed expenses

Net operating income

70,000

62,000
P

18,000

3,000

(3,000)

65,000

(3,000)

30,000

P12,000

Assume the following information for a company considering a new laborsaving machine that rents for P3,000 per year.
The total cost approach requires constructing two contribution format income
statements one for each alternative.
The difference between the two income statements of P12,000 equals the
differential benefits shown at the bottom of the right-hand column.

Using the differential cost approach is desirable for two reasons:

First, only rarely will enough information be available to prepare

detailed income statements for both alternatives.
Second, 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 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.

Due to the declining popularity of digital watches, Lovell Companys 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.
Segment Income Statement
Digital Watches
Sales
Less: variable expenses

P 500,000

Variable manufacturing
costs
Variable shipping costs
Commissions
Contribution margin
Less: fixed expenses
General factory
overhead
Salary of line manager
Depreciation of
equipment
Advertising - direct
Rent - factory space
General admin.
expenses
Net operating loss

P 120,000
5,000
75,000

200,000
P 300,000

P 60,000
90,000
50,000
100,000
70,000
30,000

400,000
P (100,000)

Also assume that an investigation has revealed that the fixed

factory overhead and fixed general administrative expenses will
affected by dropping the digital watch line. The fixed general
overhead and general administrative expenses assigned to this
would be reallocated to other product lines.

general
not be
factory
product

The equipment used to manufacture digital watches has no resale

value or alternative use.
Should Lovell retain or drop the digital watch segment?
Contribution Margin
Solution
Contribution margin lost if
digital watches are dropped
Less fixed costs that can be
avoided
Salary of the line manager
$ 90,000
Advertising - direct
100,000
Rent - factory space
70,000
Net disadvantage

Comparative Income Approach

$ (300,000)

260,000
$ (40,000)

The Lovell solution can also be obtained by preparing comparative income

statements
Comparative Income Approach
showing
Solution
results
with
Drop
and
without
Keep Digital
Digital
the
digital
Watches
Watches
Difference
watch
Sales
$ 500,000
$
$ (500,000)
Less variable expenses:
segment.
Manufacturing expenses
Shipping
Commissions
Total variable expenses
Contribution margin
Less fixed expenses:
General factory overhead
Salary of line manager
Depreciation
Advertising - direct
Rent - factory space
General admin. expenses
Total fixed expenses
Net operating loss

120,000
5,000
75,000
200,000
300,000
60,000
90,000
50,000
100,000
70,000
30,000
400,000
$ (100,000)

120,000
5,000
75,000
200,000
(300,000)

60,000
50,000
30,000
140,000
$ (140,000)

90,000
100,000
70,000
260,000
$ (40,000)

Learning objective 3
Prepare a make or buy analysis.
The Make or Buy Analysis
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.
Example
Essex Company manufactures part 4A that is used in one of its
products. The unit product cost of this part is:
Direct materials
Direct labor

9
5

Variable overhead
Depreciation of special equip.
Supervisor's salary
General factory overhead
Unit product cost

1
3
2
10
P 30

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 P25
per part.
Should we accept the suppliers offer?
Cost
Per
Unit

Outside purchase price

P 25

Direct materials (20,000 units)

Direct labor
Variable overhead
Depreciation of equip.
Supervisor's salary
General factory overhead
Total cost

9
5
1
3
2
10
P 30

Cost of 20,000 Units

Make
Buy
P 500,000
180,000
100,000
20,000
40,000
P 340,000

P 500,000

The avoidable costs associated with making part 4A include direct

materials (P180,000), direct labor (P100,000), variable overhead (P20,000),
and the supervisors salary (P0,000).
Notice that the depreciation of special equipment represents a sunk
cost. Furthermore, the equipment has no resale value, thus the special
equipment and its associated depreciation expense are irrelevant to the
decision.
The general factory overhead represents future costs that will be
incurred regardless of whether Essex makes or buys part 4A; hence, it is also
irrelevant to the decision.

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
companys 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 companys 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?

Revenue (5,000 $20)

Variable costs:
Direct materials
Direct labor
Manufacturing overhead
Marketing costs
Total variable costs
Contribution margin
Fixed costs:
Manufacturing overhead
Marketing costs
Total fixed costs
Net operating income

$100,000
$20,000
5,000
10,000
5,000
40,000
60,000
$28,000
20,000
48,000
$ 12,000

A contribution format income statement for Jets normal sales of 5,000 units
is as shown.
Assume variable cost is $8 a unit. Total variable cost would be 5,000 units
times $8 a unit.
Increase in revenue (3,000 $10)
Increase in costs (3,000 $8 variable cost)
Increase in net income

$ 30,000
24,000
$ 6,000

If Jet accepts the special order, the incremental revenue of $30,000 will
exceed the incremental costs of $24,000 by $6,000. This suggests that Jet

should accept the order. Notice that this answer assumes that the fixed costs
are unavoidable and that variable marketing costs must be incurred on the
special order.

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 companys 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.
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 companys 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.

Example
Ensign Company produces two products and selected data are shown
below:
Product
Selling price per unit
Less variable expenses per unit
Contribution margin per unit
Current demand per week (units)
Contribution margin ratio
Processing time required
on machine A1 per unit

1
$ 60
36
$ 24

2
$ 50
35
$ 15

2,000
40%
1.00

2,200
30%
min.

0.50

min.

In addition, assume that Machine A1 is the constraint, and 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?
How many units of each product can be processed through Machine A1
in one minute?
One unit of Product 1 and two units of Product 2.
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?
Product 2. With one minute of machine A1, we could make 1 unit
of Product 1, with a contribution margin of $24, or 2 units of
Product 2, each with a contribution margin of $15 per unit.
The key is the contribution margin per unit of the constrained resource.
Product
Contribution margin per unit
Time required to produce one unit
Contribution margin per minute

1
$ 24
1.00
$ 24

min.

2
$ 15
0.50
$ 30

min.

As suggested by the answer to the Quick Check question, 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.

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.

Alloting Our Constrained Resource (Machine A1)

Weekly demand for Product 2
Time required per unit

2,200
0.50

units
min.

Total time required to make Product 2

1,100

min.

Total time available

Time used to make Product 2
Time available for Product 1

2,400
1,100
1,300

min.
min.
min.

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.
This mix of production (for example, 2,200 units of product 2 and 1,300
units of product 1) would yield a total contribution margin of $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?
The additional machine time would be used to make more units of
Product 1, which had a contribution margin per minute of $24.
Because the additional machine time would be used to make more
units of Product 1, 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 earned producing more units of Product 1.

Colonial Heritage makes reproduction colonial furniture from select

hardwoods.
The companys supplier of hardwood will only be able to supply 2,000
board feet this month. Is this enough hardwood to satisfy demand?

Chairs

Tables

Selling price per unit

$80

$400

Variable cost per unit

$30

$200

Board feet per unit

10

Monthly demand

600

100

No. (2 600) + (10 100 ) = 2,200 > 2,000

Colonial Heritage needs 2,200 board feet to satisfy its demand.

The companys supplier of hardwood will only be able to supply 2,000

board feet this month. What plan would maximize profits?
Production of 600 chairs and 80 tables would maximize contribution
margin.

As before, Colonial Heritages 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?
The additional wood would be used to make tables. In this use, each
board foot of additional wood will allow the company to earn an
additional $20 of contribution margin and profit.
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.

For example, in the petroleum refining industry a large number of

products are extracted from crude oil, including gasoline, jet fuel, home
heating oil, lubricants, asphalt, and various organic chemicals.
The term joint cost is used to describe costs incurred up to the split-off
point. Joint costs are common costs incurred to simultaneously produce a
variety of end products.

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.

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.

Analysis forSell or Process Further

Per Log
Lumber

Sales value after further processing

Sales value at the split-off point
Incremental revenue
Cost of further processing

P 270
140
130
50

Sawdust

50
40
10
20

Profit (loss) from further processing

P80

P(10)

The lumber should be processed further and the sawdust should be sold at
the split-off point.