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Ch. 12 – Differential Analysis in Decision-Making

- In decision- aki g, i porta t to eed out hat’s i porta t s. hat’s ot
- Only inputs relevant to decision-making are differential costs & revenues
- Ignore irrelevant data

Differential (relevant) cost – difference in cost between any two alternatives

Differential revenue (relevant benefit) – difference in revenue between any two alternatives

Costs relevant to decision-making

 Avoidable cost – a cost that can be eliminated if you choose one alternative over
another
 Opportunity cost – potential benefit you give up when you select one alternative over
another

Costs irrelevant to decision-making

 Unavoidable cost – a ost that does ’t ha ge regardless of the solutio you hoose
 Sunk cost – already i urred a d a ’t e a oided regardless of a de isio

- In identifying relevant costs and benefits, remember that real/economic depreciation

pertains to a reduction in the resale value of an asset either over time or with use,
whereas accounting depreciation is more about matching sunk costs with the periods
that benefit from that cost
- You can either identify which costs are relevant first and then make a decision
(differential approach), or make a decision with full information (total approach).
o Produces same result
o Why use the differential approach?
 Total approa h ofte i pra ti al; o ’t al ays ha e e ough i for atio
to create a detailed comparison
 Using all costs can be confusing and detract from key information
 Irrelevant data can be used incorrectly  bad decision results

Adding or dropping product lines/segments

- Key question: How does it affect net operating income?
- Tradeoff between losses in contribution margin vs. a lessened burden of fixed costs
traceable to that product/segment
- Pay atte tio to osts that are allo ated o er all produ ts; these osts o ’t disappear if
the product line does
o Allocated fixed costs makes products appear less profitable than they actually
are
- Unprofitable products may be kept if they help sell other products or serve as a
ag et for usto ers

Make or buy decision

- Value chain – activities from development to production to after-sales service

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- Make or buy decision – decision to carry out a value-chain activity instead of buying
externally from a supplier
- Vertical integration – when a company is involved in more than one activity in the
entire value chain
- Advantages of vertical integration
o Less dependent on suppliers
o Smoother flow of parts & materials
o May control quality better
o May realize profits from parts & materials
- Advantages of using suppliers
o Economies of scale  higher quality, lower price
- Relevant costs
o Variable costs associated with making the product (DM, DL, MOH)
o Supervisor salary
o Opportunity cost of space proposed for making the parts
 Op cost of space w/o a better use = zero
 Op cost of space w/ a better use = the profit that ould’ e ee ade if
the space was used to produce something else (segment margin forgone
on a potential new product line)
- Irrelevant costs
o Common fixed costs
o Sunk costs (depreciation of equipment)

Make if avoidable costs of making < total costs of buying

Buy if avoidable costs of making > total costs of buying

Special Orders – one-ti e order that is ’t part of the o pa y’s or al o goi g usi ess
- Consider variable product costs (DM, DL, MOH)
- Profitable if incremental revenue from order > incremental costs of the order
- Make sure there’s e ough spa e to reate this spe ial order, a d that it does ’t ut i to or al
sales or undercut prices

Constraint – anything that prevents you from getting more of what you want
- Bottleneck – a step in a chain that limits total output because it has the smallest capacity
- Must decide which products/services make the best use of the bottleneck/constrained resource
- Calculate contribution margin per unit of the constrained resource (not just product with
highest overall CM) and pick the product with the higher number

Contribution margin per unit of the constrained resource = (CM/unit) / how much of the constrained resource a unit uses

- O e ay to erify that you’ e hose the highest-yielding product (given the constraint) is to
compare additional CM: Which product yields higher CM if capacity of the constraint were to
increase?
- Strengthening chains
o Identify weakest link
o Do ’t strai syste past the eak li k’s li it

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o Concentrate efforts on strengthening the weakest link

o Repeat with next weakest link

Managing constraints
- Relaxing/elevating constraint – increasing capacity of the bottleneck
o Overtime – pay up to the cost of CM/constrained resource
o Subcontracting
o Additional machines
o Shifting workers to the bottleneck process
o Focusing process improvement efforts
o Reducing defective units
 These last three = most attractive options, and may even come with additional
savings
- Linear programming – quantitative method used to find the right combo of products to produce
if there is more than one potential constraint

Joint products – products made from the same one input

- Split-off point – point in a manufacturing process where joint products become separate
products
Joint costs – costs incurred up to the split-off point, common costs incurred in order to simultaneously
produce these many end products
- Typically allocated according to sales value of end products
- Allocation needed for inventory valuation, but often extremely misleading
- Ca ’t attri ute JC to a y o e produ t, so do ’t allo ate osts to ake de isio s a out just o e
product
- JC irrelevant past split-off point

Sell or process further decisions

- Might be more profitable to sell an intermediate product instead of processing further

Use incremental analysis:

Process further if sales value created from processing alone > costs incurred from processing after the split-off
Sell if sales value created from processing alone < costs incurred from processing after the split-off

- Do ’t o sider sales value created before split-off

o (Final sales value after processing minus sales value at split-off)
- Ignore joint costs—only relevant if considering profitability of entire operation

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