1. Differential Analysis: The Key to Decision Making

2. Learning Objectives
Distinguish between relevant and irrelevant costs and revenues in (alternative-choice) decisions.
Prepare analyses showing
whether to add or drop a segment
whether to make or buy a component
whether to accept or reject a special order
the most profitable use of a scarce resource
whether to sell or further process a product

3. Decision Making – Six Key Concepts
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 revenues should be considered when making decisions.
Irrelevant costs and irrelevant revenues should be ignored when making decisions.

4. Decision Making – Six Key Concepts
The key to effective decision making is differential analysis – focusing on the future costs and revenues 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.
A future revenue that differs between any two alternatives is known as a 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.

5. Decision Making – Six Key Concepts
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 revenues that do not differ between alternatives are irrelevant to the decision-making process.

6. Decision Making – Six Key Concepts
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.

7. Identifying Relevant Costs – Example
A manager at White Co. wants to replace an old machine with a new one. What costs are relevant?

8. Identifying Relevant Costs – Example
Other fixed expenses are the same; book value of the old machine is a sunk cost. They are not relevant.

9. Types of Alternative-Choice Decisions
Adding or dropping a product or other segments.
Making or buying a component (outsourcing).
Accepting or rejecting a special order.
Rationing of a scarce resource.
Sale versus further processing.
Note: These decisions normally have a relatively short time horizon.
Time value of money and taxes are ignored.

10. General Steps in the Analysis
Define the problem/opportunity
Determine possible alternative actions/solutions
the obviously unattractive ones are eliminated
For each alternative, measure the differential (incremental) revenues, costs, or profit
Evaluate the alternatives
Reach a decision
Note: Qualitative information is sometimes more important than differential revenues and expenses.

11. Adding or Dropping a Segment
Should we add or drop a business segment, such as a product or a store?
An add or drop decision should be based only on the differential (incremental) revenues and costs. Revenue and cost items unaffected by the decision should be disregarded.
Differential revenues and costs are segment contribution margin and some traceable fixed costs.
Note: Qualitative considerations are important.

12. Adding or Dropping a Segment Example
White Company is considering dropping its digital watch segment.
The CM of the segment is $300,000.
Dropping the segment will yield the following fixed cost savings:
Salary of the division manager $ 90,000
Direct advertising ,000
Rent for factory space ,000
Should White dispose of its digital watch segment?

13. Adding or Dropping a Segment
White should not drop its digital watch segment because its fixed cost savings does not exceed lost contribution margin.
This same answer can be reached by preparing income statements with and without the segment.
What if the released resources can be used for ...?

14. Making or Buying a Component
Should we outsource a component that we are currently making? Should we make a component that we are currently outsourcing?
Dependability, quality consideration, and focus are important considerations.
A make or buy decision should be based only on the differential (incremental) costs. Cost items unaffected by the decision should be disregarded.
The cost of the buy alternative is usually easy to estimate. The more difficult problem is to find the differential costs of the make alternative.

15. Making or Buying a Component Example
El Cerrito incurs the following cost for part No. 300: Total (10,000) Per unit
Direct materials $80,000 $ 8
Direct labor ,
Variable overhead (OH) 40,
Fixed OH (traceable) 20,
Fixed OH (Common) 30,
Another company offers to sell El Cerrito the same part for $16 per unit. There are no alternative uses of the capacity that becomes available.
Should El Cerrito continue to make or buy the part?

16. Making or Buying a Component Example
Items of differential costs are as follows:
If part No is manufactured
Direct material $8
Direct labor 1
Variable OH 4
Fixed OH (part 300) 2
Total 15
Based on financial consideration alone, El Cerrito should continue to make the part.
What if the released facility can be used for ...?

17. Special Orders
Should we accept a one-time order at a price below the regular selling price (i.e., an off-price order)?
If there are no effects on the operations (e.g., the market is not spoiled), the order should be accepted if the differential revenues obtained exceed differential costs. Revenue and cost items unaffected by the decision should be disregarded.

18. Special Orders Example
Arlington Brewing Company operates a brewery with a monthly capacity of one million barrels of a beer product (Champion) that has gained significant market share. Current production and sales are 600,000 barrels a month. The selling price is $90 per barrel. The costs are as follows:
VC /barrel FC /barrel
Direct material (barley, etc.) $ 7
Direct labor
Overhead $13
Marketing costs*
Distribution costs
* Variable marketing cost is sales commission.

19. Special Orders Example
A Canadian brewery wants to buy 250,000 barrels of Champion for each of the next four months until its current brewery is renovated. It is willing to pay $45 per barrel. If Arlington accepts this order, an additional $300,000 in manufacturing costs will be incurred each month. No additional costs will be incurred for marketing & distribution.
Should Arlington accept the special order?

20. Special Orders Example
Items of differential monthly revenues and costs are:
Total revenue $11,250,000
Variable costs $8,750,000
Additional costs , ,050,000
Differential profit $ 2,200,000
Based on profit alone, Arlington should accept the offer.

21. Rationing A Scarce Resource
Usually, fixed costs are not affected by this decision.
Therefore, producing products with highest CM per unit of scarce resource maximizes total contribution margin and overall profit.

22. Rationing A Scarce Resource Example
Active Company produces two products and selected data is shown below.
A B
CM/unit $ 10 $ 12
Std. machine hrs/unit 1 hr hrs.
If only10,000 machine hours are available, which product should Active focus its efforts on?

23. Rationing A Scarce Resource Example
A B
CM/unit $ 10 $ 12
Std. requirement/unit 1 hr hrs.
CM/hour $10 $ 6
Active should focus its attention on product A, if only 10,000 machine hours are available:
Total CM = 10,000 * $10, if only A is produced
Total CM = 10,000 * $6, if only B is produced

24. 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:
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

25. Sale Versus Further Processing
Should we sell our product at some point before the final step in its production?
Costs incurred prior to the point of decision are not relevant in deciding whether to sell or further process a product (joint or otherwise).
As a general rule, a product should be further processed if the incremental revenues from processing it exceed the incremental processing costs.

26. Sensitivity analysis
All decisions involve making assumptions and estimates about the future. It is important to make note of the assumptions and estimates.
After completing the analysis, it is often useful to redo the analysis under different assumptions and estimates to determine the sensitivity of the conclusions.
With computer, the sensitivity (what if) analysis can be performed quickly.