Using Differential Analysis to Make DecisionsDifferential revenues and costs (also called relevant revenues and costs or incremental revenues and costs) represent the difference in revenues and costs among alternative courses of action. Show
Analyzing this difference is called differential analysis (or incremental analysis). The general rule is to select the alternative with the highest differential profit. Relevant InformationAvoidable and Unavoidable Costs in Differential AnalysisDifferential analysis requires that we consider all differential revenues and costs—costs that differ from one alternative to another—when deciding between alternative courses of action. Avoidable costs—costs that can be avoided by selecting a particular course of action— are always differential costs and must be considered when deciding between alternative courses of action.
Opportunity costs—the benefits foregone when one alternative is selected over another—are differential costs, and must be included when performing differential analysis. Sunk costs—costs incurred in the past that cannot be changed by future decisions—are not differential costs because they cannot be changed by future decisions. Direct fixed costs—fixed costs that can be traced directly to a product line or customer—are differential costs and therefore pertinent to making decisions. However, we must review these costs on a case-by-case basis because some direct fixed costs may not be considered differential in spite of being traced directly to a product line. For example, a five-year lease on a warehouse used solely for one product line is a direct fixed cost but not a differential cost because the costs will continue even if the product line is eliminated. Allocated fixed costs—fixed costs that cannot be traced directly to a product—are typically not differential costs. For example, if a product line is eliminated, these costs are simply allocated to the remaining product lines. We can differential analysis to assist in making the following types of decisions:
Decision-Making ModelSpecial Order Pricing DecisionMake or Buy DecisionsProduct Line DecisionsA product line is a group of related products. Companies must continually assess whether they should add new product lines, and whether they should discontinue current product lines. Differential analysis provides a format for these types of decisions. How would differential analysis be used to make a product line decision? Company would like to consider two alternatives. Alternative 1 is to retain all three product lines, and Alternative 2 is to eliminate the a specific product line. The variable costs are related directly to each product line, and thus are eliminated if the product line is eliminated. That is, all variable costs are differential costs for the two alternatives facing the Company. Notice that two lines appear for fixed costs: direct fixed costs and allocated fixed costs. What is the difference between direct fixed costs and allocated fixed costs? Direct fixed costs are fixed costs that can be traced directly to a product line. Direct fixed costs are often differential costs. For example, the salary of the manager responsible for a product is easily traced to the product line. If this product line is eliminated, the product line manager’s salary is also eliminated (unless the product line manager has a long-term employment contract). Allocated fixed costs (also called common fixed costs) are fixed costs that cannot be traced directly to a product line, and therefore are assigned to product lines using an allocation process. Allocated fixed costs are typically not differential costs. Rent for the retail store is an example of an allocated fixed cost that is not a differential cost for the two alternatives facing the Company. How are a Company’s allocated fixed costs assigned to individual product lines? Company’s total allocated fixed costs are allocated based on sales. Sales revenue for Product 1 is 75 percent of total company sales. Thus 75 percent of all allocated fixed costs are assigned to that product line. Will dropping a product line result in higher company profit? Panel A shows the income statement for Alternative 1: keeping all three product lines. Panel B shows the income statement for Alternative 2: dropping the charcoal barbecues product line. And panel C presents the differential analysis for the two alternatives. The differential analysis in panel C shows that overall profit will decrease by $10,000 if the charcoal barbecue product line is dropped. However, management may want a more concise explanation of why profit is $10,000 higher when all three product lines are maintained. Company will lose sales revenue of $90,000 if it drops the charcoal barbecues product line. However, it saves variable costs of $40,000 and direct fixed costs of $40,000 if it drops the charcoal barbecues product line. Because the $80,000 in cost savings is not enough to make up for the $90,000 loss in sales revenue, profit will decline by $10,000 (= $80,000 − $90,000). Misleading Allocation of Fixed CostsHow can a product line show a loss while the company as a whole is better off keeping this product line? Allocated costs are typically not differential costs, and therefore are typically not relevant to the decision. Including Opportunity Costs in Differential AnalysisManagers must often consider the impact of opportunity costs when making decisions. An opportunity cost is the benefit foregone when one alternative is selected over another. Opportunity costs can also be included in the differential analysis format. Sunk Costs and Differential AnalysisA sunk cost is a cost incurred in the past that cannot be changed by future decisions. The original cost of this store equipment is a sunk cost and should have no bearing on the decision whether to eliminate charcoal barbecues. As a general rule, sunk costs are not differential costs. Customer DecisionsUse differential analysis to decide whether to keep or drop customers. Managers use differential analysis to determine whether to keep or drop a customer. The format is similar to the differential analysis format used for making product line decisions. However, sales revenue, variable costs, and fixed costs are traced directly to customers rather than to product lines. How does the differential analysis format differ for customer decisions compared to product line decisions? Instead of tracing revenues, variable costs, and fixed costs directly to product lines, we track this information by customer. Fixed costs that cannot be traced directly to customers are allocated to customers. Let’s identify the similarities and differences between the two formats. Thus allocated fixed costs are not differential costs. Theory of ConstraintUsing Activity-Based Costing to Assess Customer ProfitabilityActivity-based costing is a refined approach to allocating costs to products or customers. Activity-based costing first assigns costs to activities and then to products or customers based on their use of the activities. The cost information provided by activity-based costing is generally regarded as more accurate than most traditional costing methods. When assessing customer profitability, costs can be assigned to customers based on each customer’s use of activities. Customer costs are measurable across four categories of activities:
With the help of activity-based costing, costs can be assigned to activities within each category. These costs are then allocated to customers based on each customer’s use of activities. A significant advantage of using activity-based costing is having accurate data for decision-making purposes, particularly in the area of differential analysis. Qualitative Factors in Differential AnalysisThis chapter has focused on using relevant revenue and cost information to perform differential analysis. Using these quantitative factors to make decisions allows managers to support decisions with measurable data. Although using quantitative factors for decision making is important, management must also consider qualitative factors. Related Topics
How do you choose between two projects using NPV?Net Present Value Decision Rules. Independent projects: If NPV is greater than $0, accept the project.. Mutually exclusive projects: If the NPV of one project is greater than the NPV of the other project, accept the project with the higher NPV. If both projects have a negative NPV, reject both projects.. How do you compare two projects with different lives?In order to compare projects with different lives, we compute the NPV of an infinite replication of the investment project. For example, let Projects A and B be two mutually exclusive investment projects with the following cash flows.
How do you choose between two mutually exclusive projects?In case of mutually exclusive projects, the project with highest net present value or the highest IRR or the lowest payback period is preferred and a decision to invest in that winning project exclused all other projects from consideration even if they individually have positive NPV or higher IRR than hurdle rate or ...
What should be the criteria of selection when choosing among mutually exclusive projects?In such cases, while choosing among mutually exclusive projects, one should always select the project giving the largest positive net present value using the appropriate cost of capital or predetermined cut-off rate.
When selecting the best project from a group of mutually exclusive projects you should choose the project with the highest?2) For mutually exclusive projects, the project with the higher IRR is the correct selection.
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