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Ateneo de Naga University

College of Business and Accountancy

Department of Accountancy
Management Accounting II RF LIM, CPA

DIFFERENTIAL ANALYSIS: Short-term Decision Making

Purpose: Every decision involves choosing from among at least two alternatives. In making a
decision, the costs and benefits of one alternative must be compared to the costs and benefits of
other alternatives. The key to making such comparisons is differential analysis focusing on the
COSTS and BENEFITS that DIFFER between alternatives.

Relevant Costing is a management accounting toolkit that helps managers reach decisions when
they are posed with the following questions (short-term non-routine cases):
1. Make or Buy Decision - whether to buy a component from an external vendor (Outsource)
or manufacture it in house.
2. Special Order Pricing - whether to accept a special order.
3. Sell or Reprocess Further
4. Add or Drop Product Line or Segment - Whether to discontinue a product line/segment.
5. Scarce Resource Decision

The Decision Making Process:

1. Defining the problem
2. Setting criteria
3. Identifying alternative courses of action
4. Determination of possible consequences of the alternatives
5. Evaluating alternatives
6. Choosing the best alternatives
7. Choosing the best alternative and making the decision.

Qualitative and Quantitative Factors:

Qualitative Factors those that cannot easily and accurately be expressed in terms of
money or any other numerical unit of measures.
Quantitative Factors those that can be easily be expresses in terms of money or other
units of measure.

Approaches in Solving Decision Making Problems:

1. Total Approach the total revenues and costs are determined for each alternative, and the
results are compared to serve as bases for making decisions.
2. Differential Analysis involves finding the most profitable alternative by analyzing the
differential revenues and costs.

Definition of Terms:
Avoidable Costs cost that can be eliminated by choosing one alternative over another.
This is synonymous with relevant costs.
Relevant Costs/Revenues the future revenues/costs that are expected to be different
under each alternative courses of action.
Differential Costs the increase (increments) or decreases (decrements) in total costs
between two alternatives.
Opportunity Costs represents opportunity economic benefits that are forgone as a
result of pursuing some course of action.
Sunk Costs cost that has already been incurred and cannot be avoided regardless of
what a manager decides to do.
Joint Costs costs that are incurred up to the split-off point in a process that produces
joint products.
Joint Products two or more products that are produced from a common input.
Split-off Point the point in the manufacturing process where some or all of the joint
products can be recognized as individual products.

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Bottleneck A machine or some other part of a process that limits the total output of the
entire system.
Constraint a limitation under which a company must operate, such as limited available
machine time or raw materials that restricts the companys ability to satisfy demand.
Imputed Costs assumed or hypothetical costs representing the costs or value of a
resource that is utilized for a specific purpose.

MAKE OR BUY DECISION a decision concerning whether an item should be produced

internally or purchased from an outside supplier.
Make-or-Buy decision (also called the outsourcing decision) is a judgment made by management
whether to make a component internally or buy it from the market. While making the decision,
both qualitative and quantitate factors must be considered.
The quantitative factors are actually the incremental costs resulting from making or buying the
component. For example: incremental production cost per unit, purchase cost per unit,
production capacity available to manufacture the component, etc.
Example No. 1
The estimated costs of producing 6,000 units of a component are:
Unit Total
P10 P60,00
Direct Material 0
Direct Labor 8 48,000
Applied Variable Factory 9
Overhead 54,000
Applied Fixed Factory 12
Overhead 72,000
P1.5 per direct labor dollar
P39 P234,0

The same component can be purchased from market at a price of P29 per unit. If the component
is purchased from market, 25% of the fixed factory overhead will be saved.

1. Should the component be purchased from the market?
2. What is the cost of making a component internally for decision making? And what is cost
of purchasing for decision making?
3. What is the incremental cost of making or of purchasing?

Example No. 2
Mountain Goat Cycles is now producing the heavy-duty gear shifters used in its most
popular line of mountain bikes. The companys Accounting Department reports the following
costs of producing 8,000 units of the shifter internally each year:
Per 8,000
Unit units
Direct Materials P6 P48,000
Direct Labor 4 32,000
Variable Overhead 1 8,000
Supervisor's Salary 3 24,000
Depreciation of Special Equipment 2 16,000
Allocated General Overhead 5 40,000
Total Cost P21 P168,000

An outside supplier has offered to sell 8,000 shifters a year to Mountain Goat Cycles for a price of
P19 each, or a total of P152,000.

1. What is the total relevant cost to make? Relevant cost to Buy?
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2. What is the difference in cost between the two alternatives?
3. Should the company continue to make or should otherwise purchase?

Example No. 3 (Use the information in Example No. 2)

Consider that the space that is being used to produce shifters could be used for some
other purpose. Assume that the space could be used otherwise to produce a new cross-country
bike that would generate a segment margin of P60,000 per year.

1. What is the total relevant cost to make? Relevant cost to Buy?
2. What is the difference in cost between the two alternatives?
3. Should the company continue to make or should otherwise purchase?


Special order pricing is a technique used to calculate the lowest price of a product or
service at which a special order may be accepted and below which a special order should be
rejected. Usually a business receives special orders from customers at a price lower than normal.
In such cases, the business will not accept the special order if it can sell all its output at normal
price. However when sales are low or when there is idle production capacity, special orders
should be accepted if the incremental revenue from special order is greater than incremental

Example No. 1
Probinsyano Company is producing, on average, 10,000 units of product A per month despite
having 30% more capacity. Costs per unit of product A are as follows:
Direct Material P8.00
Direct Labor 5.00
Variable Factory 2.00
Variable Selling 0.50
Fixed Factory 3.00
Fixed Office Expense 2.00
The company received a special order of 2,000 units of product A at P17.00 per unit from a new
1. What is the increment cost per unit for the special order?
2. Should the company accept the special order, provided that the customer has agreed to
pay the variable selling expenses in addition to the price of the product?
Example No. 2
Mountain Goat Cycles has just received a request from the Seattle Police Department to produce
100 specially modified mountain bikes at a price of P558 each. The bikes would be used to patrol
some of the more densely populated residential sections of the city. Mountain Goat Cycles can
easily modify its City Cruiser model to fit the specifications of the Seattle Police. The normal
selling price of the City Cruiser bike is P698, and its unit product cost is P564 as shown below
Direct materials P372
Direct labor 90
Manufacturing overhead 102
Unit product cost P564

The variable portion of the above manufacturing overhead cost is P12 per unit. The order would
have no effect on the companys total fixed manufacturing overhead costs.

The modifications requested by Seattle Police Department consists of welded brackets to hold
radios, nightsticks, and other gear. These modifications would require P34 in incremental variable
costs. In addition, the company would have to pay a graphics design studio P2,400 to design and

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cut stencils that would be used for spray painting the Seattle Police Departments logo and other
identifying marks on the bikes.

This order should have no effect on the companys other sales. The production manager says
that she can handle the special order without disrupting any of the companys regular scheduled

1. Compute the incremental revenue of accepting the special order?
2. Compute the incremental cost of accepting the special order?
3. What is the incremental net operating income?


A decision whether or not to continue an old product line or department, or to start a new one is
called an add-or-drop decision. An add-or-drop decision must be based only on relevant
Relevant information includes the revenues and costs which are directly related to a product line
or department. Examples of relevant information are sales revenue, direct costs, variable
overhead and direct fixed overhead. Such decision must not be based on irrelevant information
such as allocated fixed overhead because allocated fixed overhead will not be eliminated if the
product line or department is dropped.
Example No. 1
A company has three products: Product A, Product B and Product C. Income statements of the
three product lines for the latest month are given below:
Product Line A B C
Sales P467,0 P314,0 P598,0
00 00 00
Variable Costs 241,00 169,00 321,00
0 0 0
Contribution P226,0 P145,0 P277,0
Margin 00 00 00
Direct Fixed Costs 91,000 86,000 112,00
Allocated Fixed 93,000 62,000 120,00
Costs 0
Net Income P42,00 P45,00
0 P3,000 0

Required: Use the incremental approach to determine if Product B should be dropped.

Example No. 2
Bed and Bath, a retailing company, has two departments, Hardware and Linen. The companys
most recent monthly contribution format income statement follows:
Total e Linens
P3,000,0 P1,000,0
Sales P4,000,000 00 00
Variable Costs 1,300,000 900,000 400,000
Contribution Margin 2,700,000 0 600,000
Fixed Expenses 2,200,000 0 800,000
P700,00 (P200,0
Net Operating Income (Loss) P500,000 0 00)

A study indicates that P340,000 of the fixed expenses being charged to Linens are sunk costs or
allocated costs that will continue even if the Linens Department is dropped. In addition, the
elimination of the Linens Department will result in a 10% decrease in sales of the hardware

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1. If the Linens Department is dropped, what will be the effect on the net operating income of
the company as a whole?

Example No. 3
AudioMart is a retailer of radios, stereos and televisions. The store carries two portable sound
systems that have radios, tape players and speakers. System A, of slightly higher quality than
System B, costs P20 more. With rare exceptions, the store also sells a headset when a system is
sold. The headset can be used with either system. Variable-costing income statements for the
three products follows:
System System Heads
A B et
Sales P45,000 P32,500 P8,000
Variable Costs 20,000 25,500 3,200
Contribution Margin 25,000 7,000 4,800
Fixed Costs* 10,000 18,000 2,700
Net Operating Income (P11,00 P2,10
(Loss) P15,000 0) 0

*This includes common fixed costs totaling P18,000, allocated to each product in proportion to its
The owener of the store is concerned about the profit performance of System B and is
considering dropping it. If the product is dropped, sales of System A will increase by 30%, and
sales of headsets will drop by 25%.
1. Prepare segmented income statements for the three products using a better format.
2. Prepare segmented income statements for System A and the headsets assuming that
System B is dropped. Should System B be dropped?
3. Suppose that a third system, System C, with a similar quality to System B, could be
acquired. Assume that with C the sales of Awould remain unchanged; however, C would
produce only 80% of the revenues of B, and sales of headsets would drop by 10%. The
contribution margin ratio of is 50%, and its direct fixed costs would be identical to those of
B. Should System B be dropped and replaced with System C?


A decision whether to sell a joint product at split-off point or to process it further and sell it in a
more refined form is called a sell-or-process-further decision. Joint products are two or more
products which have been manufactured from the same inputs and in a same production process
(i.e. a joint process). The point at which joint products leave the joint process is called split-off
Some of the joint products may be in final form ready for sale, while others may be processed
further. In such cases managers have to decide whether to sell the unfinished goods at split-off
point or to process them further. Such decision is known as sell-or-process-further decision and it
must be made so as to maximize the profits of the business.
A sell-or-process-further analysis can be carried out in three different ways:
Incremental (or Differential) Approach calculates the difference between the
additional revenues and the additional costs of further processing. If the difference is
positive the product must be processed further, otherwise not.
Opportunity Cost Approach calculates the difference between net revenue from further
processed product and the opportunity cost of not selling the product at split-off point. If
the difference is positive, further processing will increase profits.
Total Project Approach (or the comparative statement approach) compares the profit
statements of both options (i.e. selling or further processing) separately for each product.
The option generating higher profit is chosen.

Example No. 1
Product A and B are produced in a joint process. At split-off point, Product A is complete whereas
product B can be process further. The following additional information is available:
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Product A B
Quantity in Units 5,00 10,00
0 0
Selling Price Per
At Split-Off P10 P2.5
If Processed P5
Costs After Split-Off P20,00
Required: Perform sell-or-process-further analysis for product B.
Example No. 2
Trio Company manufactures three products from a common input in a joint processing
operations. Joint processing costs up to the split off point total P350,000 per quarter. The
company allocates this costs to the joint products on the basis of their relative sales value at the
split off point. Unit selling prices and total output at the split off point are as follows:

Produc Quarterly
t Selling Price Output
A P16 per kilo 15,000 kilos
B P8 per kilo 20,000 kilos
P25 per
C gallon 4,000 gallons

Each product can be processed further after the split off point. Additional processing requires no
special facilities. The additional processing costs (per quarter) and unit selling prices after further
processing are given below:
Produc Selling
t Prices
A P63,000 P20 per kilo
B 80,000 P13 per kilo
C 36,000 P32 per gallon
1. Which product or products should be sold at the split off point and which product or
products should be processed further?


Scarce resource utilization (or allocation) decision is a judgment regarding the best use of scarce
resources so as to maximize the total net income of a business. Scarcity of different resources
puts constraints on the amount of product that can be produced using those resources. For
example, a business may have limited number of machine hours to utilize in production. Scarce
resource allocation decision is also called limiting factors decision.
When resources are abundant, products generating relatively higher contribution margin per unit
are preferred because it leads to highest net income. However when resources are scarce, a
decision in this way is unlikely to maximize the profit. Instead the allocation of a scarce resource
to various products must be based on the contribution margin per unit of the scarce resource
from each product.
A simple scarce resource allocation decision involves the following steps:
1. Calculate the contribution margin per unit of the scarce resource from each product.
2. Rank the products in the order of decreasing contribution margin per unit of scarce
3. Estimate the number of units of each product which can be sold.
4. Allocate scarce resource first to the product with highest contribution margin per unit of
scarce resource, then to the product with next highest contribution margin per unit of
scarce resource.

Example No. 1
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A company has 4,000 machine hours of plant capacity per month which are to be allocated to
products A and B. The following per unit figures relate to the products:
Product A B
Sale Price P30 P24
0 0
Direct Material 100 70
Direct Labor 65 50
Variable Overhead 20 40
Fixed Overhead 15 30
Variable Operating 40 20
Total Costs P24 P21
0 0
Net Income P60 P30
Machine Hours Required 1.5 1.0

1. Assuming that the company can sell all its output, determine how many machine hours
shall be allocated to each product.

Example No. 2
Verto Company is able to produce two products, R and T, with the same machine in its factory,
The following information is available.
Product Product
Selling price per unit P120 P160
Variable cost per unit 65 90
Contribution margin per unit P55 P70
Machine hours to produce 1
unit 0.2 hour 0.5 hour
Maximum unit sales per 350
month 1,100 units units

The company presently operates the machine for a single eight-hour shift for 22 working days
each month. Management is thinking about operating the machine for two shifts, which will
increase its productivity by another eight hours per day for 22 days per month. This change
would require P30,000 additional fixed costs per month.

1. Determine the contribution margin per machine hour that each product generates.
2. How many units of Product R and Product T should the company produce if it continues to
operate with only one shift? How much total contribution margin does this mix produce
each month?
3. If the company adds another shift, how many units of Product R and Product T should it
produce? How much total contribution margin would this mix produce each month? Should
the company add new shift?
4. Suppose that the company determines that it can increase Product Rs maximum sales to
1,350 units per month by spending P9,000 per month in marketing efforts. Should the
company pursue this strategy and the double shift?

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