1. Differential Analysis: The Key to Decision Making Chapter 10
Introduction to Managerial Accounting, Brewer, Garrison,Noreen
Power Points from website - adapted by Cynthia Fortin, CPA, CMA

2. relevant Costs and benefits that differ between alternatives
Costs that are avoidable
Costs that differ between alternatives are called relevant costs. Benefits that differ between alternatives are relevant benefits.  

3. Incremental : added costs or revenues
Differential : difference of costs and revenue between alternatives

4. Keys to Successful Decision-Making
only on relevant costs
2. Ignore sunk costs and future
costs and benefits that do not
differ between the alternatives.
The keys to successful decision-making include:
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.

5. 3. Consider qualitative information is vital to decision-making.

6. Different Costs for Different Purposes
Costs that are relevant in one decision situation may not be relevant in another context.
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.

7. Each decision situation requires the manager to examine the data at hand and isolate the relevant costs.

8. Differential Cost Advantages
1. Only rarely will enough information be available to prepare detailed income statements for both alternatives.
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.

9. Differential Cost Advantages
2. Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical.

10. Keep Drop Segments keep or
Calculate Contribution margin that would disappear if segment is dropped. Put results as negative.
2. Calculate fixed costs that would disappear if segment is dropped.
3. Add (1) to (2). If result is negative
4. Evaluate significant qualitative consequences.
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.
keep

11. Keep Drop Segments keep. or
Calculate Contribution margin that would disappear if segment is dropped. Put results as negative.
2. Calculate fixed costs that would disappear
if segment is dropped.
3. Add (1) to (2). If result is negative
4. Evaluate significant qualitative consequences.
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.
keep.

12. Illustration
The management of Bayside Company is considering whether one of the departments in its retail stores should be eliminated.
The contribution margin in the department is $150,000 per year.
Fixed expenses allocated to the department are $130,000 per year.
It is estimated that $120,000 of these fixed expenses will be eliminated if the department is discontinued.
Part (a)
Which costs are irrelevant to this decision?
The common fixed costs of $10,000 (or $130,000 - $120,000) are irrelevant to this decision.

13. Part (b)
If the department is eliminated, what will be the impact on the company’s overall net operating income?
CM that would be lost if department is discontinued $(150,000)
Less fixed costs that can be avoided if department
is discontinued ,000
Increase (decrease) in net operating income (30,000)
Based on this information alone, because the company’s net operating income would decrease by $30,000 per year, management should this department.
keep

14. Make or Buy Outsourcing: Insourcing:
Purchasing goods or services from outside vendor or supplier.
Insourcing:
Producing goods or services within an organization
May require expanding to increase capacity
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.

15. Calculate total amount to pay supplier.
Calculate total differential costs if company chooses to make.
Calculate difference between the 2 options.
Select lowest cost option.
Analyze qualitative factors

16. Qualitative factors Logistical considerations distance from plant
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.

17. Qualitative factors
Dependance on supplier can increase risk:

18. Qualitative factors

19. Make or Buy Analysis
Idle space (caused by outsourcing) that has no alternative has an opportunity cost of $ 0.

20. No longterm implications There is existing idle capacity
Usually the price is lower than the regular product
There are variable and fixed relevant costs incurred
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.

21. Company must decide if the decision creates incremental net operating income
Fixed costs are sunk costs, therefore irrelevant
Absorption costing is not appropriate in the decision

22. Calculate total revenue generated by special order
Calculate total incremental costs
(1) – (2) => if positive accept the order
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.

23. Qualitative factors Will this impact regular customers?
Is there potential future business?

24. Utilization of a constrained resource
Effectively managing the constraint is the key to success.
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.

25. Theory of Constraints 2. Allow the weakest link to set the tempo.
Only actions that strengthen the weakest link in the “chain” improve the process.
2. Allow the weakest link to set the tempo.
3. Focus on improving the weakest link.
1. Identify the weakest link.
The Theory of Constraints offers a four-step approach to process improvement:
 Identify the weakest link in the chain, which is the constraint.
 Do not place a greater strain on the system than the weakest link can handle – if you do, the chain will break.
 Concentrate improvement efforts on strengthening the weakest link.
 If the improvement efforts are successful, eventually the weakest link will improve to the point that it is no longer the weakest link. At this point, a new weakest link must be identified and the improvement process starts over again.
4. Recognize that the weakest link is stronger.

26. Utilization of a constrained resource
Calculate each product’s Contribution Margin (CM) per unit.
Identify constraining resource and the quantity of that resource that is consumed by the unit.
Divide (CM) by unit of constrained resource.

27. Utilization of a constrained resource
4. Rank products from highest CM to lowest CM.
5. The CM must be viewed in relation to the amount of the constrained resource each product requires.

28. Managing Constraints
Increase the capacity of a bottleneck, called relaxing constraint, such as:
Working overtime on the bottleneck.
Subcontracting some of the processing that would be done at the bottleneck.
Investing in additional machines at the bottleneck.
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:
Working overtime on the bottleneck.
Subcontracting some of the processing that would be done at the bottleneck.
Investing in additional machines at the bottleneck.
Shifting workers from non-bottleneck processes to the bottleneck.
Focusing business process improvement efforts on the bottleneck.
Reducing defective units processed through the bottleneck.
These methods and ideas are all consistent with the Theory of Constraints, which was introduced in Chapter 1.
If a company has more than one potential constraint, the proper “mix” of products can be found using a quantitative method known as linear programming, which is covered in quantitative methods and operations management courses.

29. Managing Constraints
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.

30. 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
Review the information provided about Colonial Heritage. Is this enough hardwood to satisfy demand?

31. 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
No. Colonial Heritage needs 2,200 board feet to satisfy its demand.
(2  600) + (10  100 ) = 2,200 > 2,000

32. 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
The company’s supplier of hardwood will only be able to supply 2,000 board feet this month. What plan would maximize profits?

33. 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
Production of 600 chairs and 80 tables would maximize contribution margin.

34. 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
Read this information about Colonial Heritage. Up to how much should Colonial Heritage be willing to pay above the usual price to obtain more hardwood?

35. Quick Check 
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.
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
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.

36. Sell or Process further Joint Product Costs and Contribution Margin
When 2 or more products are produced from a common input.
Split-off point is when the diffferent products are separated.
Learning objective number 7 is to prepare an analysis showing whether joint products should be sold at the split-off point or processed further.

37. Joint Products Split-Off Point
Petroleum refining industry, a large number of products are extracted from crude oil: gasoline, jet fuel, home heating oil, lubricants, asphalt, and various organic chemicals.
Oil
Common
Production
Process
Joint
Input
Gasoline
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.
Chemicals
Split-Off
Point

38. Joint Products Final Sale Final Sale Separate Split-Off Product Point
Joint costs
are incurred
up to the
split-off point
Separate
Processing
Final
Sale
Oil
Common
Production
Process
Joint
Input
Final
Sale
Gasoline
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.
Separate
Processing
Final
Sale
Chemicals
Separate
Product
Costs
Split-Off
Point

39. Process further or Joint costs are irrelevant From the split-off point
they cannot be avoided.
Joint costs are common and should not be included in making decisions

40. Process further or 1.Sales value if processed further minus
Sales value at the split-off
point.
2. Cost of further processing
beyond the split-off point.
3. (1) – (2). If positive then Process further