1. Differential Analysis: Relevant Costs – the Key to Decision Making
November 25, 2015
Differential Analysis: Relevant Costs – the Key to Decision Making
Chapter 11: Relevant Costs for Decision Making.
Making decisions is one of the basic functions of a manager. To be successful in decision making, managers must be able to tell the difference between relevant and irrelevant data and must be able to correctly use the relevant data in analyzing alternatives. The purpose of this chapter is to develop these skills by illustrating their use in a wide range of decision-making situations.

2. Today’s Agenda Relevant Costs vs. Irrelevant Costs
Differential Approach vs. Total Cost Approach
Product Transfer Decision Example
Constrained Resources

3. Relevant Costs
Costs that are relevant to decision making are those costs which differ between two or more alternatives
Differential costing
Costs that are irrelevant to decision making are those that cannot be altered
Sunk costs
Future costs that cannot be changed
By definition, these costs will not be different from each other in differing scenarios
These costs are unavoidable
Costs that are relevant to one decision may not be relevant to a different decision
One can use a total cost approach as opposed to a differential cost approach

4. Total Cost versus Differential Cost Approach
Total Cost Approach
Factor in ALL costs
More time consuming
Provides a complete picture and budget basis
Differential Cost Approach
Only factor in relevant costs; ie, those that differ between scenarios
Quicker
Does not provide the full cost picture
Either approach should lead to the same business decision conclusion

5. Total and Differential Cost Approaches
Using the differential approach is desirable for two reasons:
Only rarely will enough information be available to prepare detailed income statements for both alternatives.
Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical.
Using the differential approach is desirable for two reasons:
Only rarely will enough information be available to prepare detailed income statements for both alternatives.
Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical.

6. Relevant Costs and Benefits
A relevant cost is a cost that differs between alternatives.
A relevant benefit is a benefit that differs between alternatives.
Costs that differ between alternatives are called relevant costs. Benefits that differ between alternatives are relevant benefits.  

7. 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.
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:
A sunk cost is a cost that has already been incurred and cannot be avoided regardless of what a manager decides to do.
A future cost that does not differ between alternatives is never relevant in a decision.

8. Keys to Successful Decision-Making
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.
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.

9. 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.
Be mindful and think through each cost for each circumstance
What are relevant costs for assessing whether to invest in a university degree?
Tuition & books?
What is irrelevant?
Food?
Accommodation?
What are relevant benefits?
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.

10. University Degree – Is it worth it?
Analyze whether it is worth the investment of your time and money to obtain a university degree
What are the benefits?
What are the costs?
Use the differential approach
Which costs and benefits are relevant?
What do you conclude?
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.

11. Production Transfer Decision
James Company manufactures Switches
It manufactures and sells its products in North America
Its best customer has received a price quote from James Co’s competitor for $7,000 per unit
The customer expects to grow significantly and says that costs are its #1 issue
What would happen to the company if it matched the competitor’s quote?
What should James Co do?

12. Production Transfer Decision
James Co options:
Keep prices the same and hope the customer stays
Suggest the extra cost is provided in value added service
Argue that James Co knows the customer better & can better serve it
Argue that James Co quality and timeliness of delivery is superior
Match the price, lose money and try to cut costs over time
Manufacture in a lower cost location
Investigate whether James Co can manufacture the product profitably elsewhere

13. Production Transfer Decision
You are the head of managerial accounting and you learn the following about producing in China:
Component parts can be sourced for 70% of current costs
Because they are made in China and would not require shipping
Labour costs are 20% of what they are in North America
Shipping completed product back to North America would cost $250 per unit AND it would add two weeks to the delivery schedule
Power is approximately the same cost in both locations
If the company transferred production, the customer would conduct a detailed one-time facility inspection at a cost to James Co of $2 million
There are other “one-time” costs
Building up extra inventory for the transfer period to ensure continuity of supply
Parallel production until China facility is in steady-state
It would take a full 12 months to sub-lease the North American facility
What information is missing to make a decision whether to transfer production?

14. Product Transfer Decision

15. Product Transfer Decision
Do you have a conclusion? Is there anything analysis still missing?

16. Product Transfer Decision
There has been no consideration for additional inventory required due to increase in delivery time
Two weeks additional inventory costs
However, there is less inventory ($ value) because it now costs less
Also, still need to consider “one-time” costs
How can these one-time costs be addressed?

17. 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.
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.
To assess this impact, it is necessary to carefully analyze the costs.

18. A Contribution Margin Approach
DECISION RULE Chen Co should drop its digital watch segment only if its profit would increase. Chen Co will compare the contribution margin that would be lost to the costs that would be avoided if the line was to be dropped.
To determine how dropping this line will affect the overall profits of the company, Lovell will compare the contribution margin that would be lost to the costs that would be avoided if the line were to be dropped.
Lovell should drop the digital watch segment only if its profit would increase. This would only happen if the fixed cost savings exceed the lost contribution margin.

19. 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.
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.
Should Chen Co, manufacture it’s own watch straps?
Or, would it be better for them to buy them from a supplier?
What are the incremental benefits? Costs? Risks?

20. 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.
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. 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.
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.

22. 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.
Remember the Balance Sheet – ROI remains a factor
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 margin.
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.

23. 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.
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.
These methods and ideas are all consistent with the Theory of Constraints, which was introduced in Chapter 1.

24. 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.
In some industries, a number of end products are produced from a single raw material input. When two or more products are produced from a common input these products are known as joint products. The split-off point is the point in the manufacturing process at which the joint products can be recognized as separate products.

25. 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.
This is the corollary of the “Make or Buy” decision, but further down the production line.
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.

26. Tutorial Assignment Review Build versus Buy Decisions
All Case Study models to be functioning