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Chapter 12 Differential Analysis

Managers have to make many decisions including:


- What products to sell?
- Do we make or buy the raw materials we need for production?
- Should we accept a special order project at a special price?

Differential analysis focusing on the costs and benefits that differ between alternatives when making
decisions.
- Differential cost (relevant costs) difference in cost between any two alternatives
- Differential revenue (relevant benefits) difference in revenue between any two alternatives

*Costs and Revenues that do not differ between alternative options are irrelevant to decision making.
Irrelevant data can be ignored, so we must be able to tell the difference.

Avoidable cost a cost that can be eliminated by choosing one alternative over another.
- For example decision of going to movies or stay home and rent DVD
o If we choose going out to movies, the cost of renting a DVD is avoidable
o If we choose staying home and renting DVD, the cost of going out to movies is avoidable
o Rent on your apartment is unavoidable, not matter what option is chosen

Avoidable costs are relevant costs (cost of going out to movie or staying in and renting DVD).
Unavoidable costs are irrelevant costs (cost of apartment rent).

Sunk Cost cost that has already been incurred and cannot be avoided, no matter what a manager
decides to do
- Sunk costs are irrelevant costs

Opportunity Cost potential benefit that is given up when one alternative is selected over another

Decision to Add or Drop Product Lines or Segments

The decision to add or drop a product line/segment, usually all depends on the impact to net operating
income. However, this decision must be carefully analyzed by costs to get an accurate decision.

Discount Drug Company textbook example:


Discount Drug Co has 3 major product lines, drugs, cosmetics, and housewares. They are considering
whether or not to keep or drop the housewares product line.
**At first glance, looks like if we dropped the housewares, would give $8,000 more to Net Operating
Income, but this isnt really the case. We need to review the costs in more detail for fixed costs that can
be avoided and cant be avoided if housewares are dropped. Only the costs that differ by dropping
housewares are relevant.
- Also if the company isnt able to avoid as much fixed costs as it loses in Contribution Margin, then
the housewares should be kept.
o Manager should ask, what costs can I avoid if I drop this product line?

Analyze Fixed Costs:


With this information, management determines this:

Then re-analyze based on differences:

Comparative Format:
Decision to Make or Buy

Vertically integrated when a company is involved in more than one activity in the whole value chain.
- Value chain are all the steps necessary to develop and sell a product

Make or Buy decision the decision to carry out one of the activities in the value chain internally, rather
than to buy externally from a supplier

Advantages of vertical integration:


- An integrated company is less dependent on its suppliers and may be able to ensure a smoother
flow of parts and materials
- Company can control quality better by producing their own parts and materials, rather than relying
on the quality control standards of outside
- Company can realize profits from the parts and materials that it is making rather than buying

Mountain Goat Cycles textbook example

Mountain Goat Cycles is currently making heavy-duty gear shifters, a material that is used in its line of
mountain bikes. Accounting department reports the below costs to produce the 8,000 units that are
needed each year.

Outside supplier has offered to sell 8,000 gear shifters to Mountain Goat Cycles at a price of $19 each, or
total of $152,000 (8,000 X $19).

Focus on relevant costs


- Depreciation isnt relevant because the purchase of equipment to make the part is a sunk cost
- Overhead is common to all products produced in the factory, so total amount would be unchanged
o If total cost doesnt change whether we make or buy, the cost is not relevant
**When the cost that are not relevant are pulled out, the cost of making the parts is cheaper than
buying from the outside supplier. Decision would be to keep making.

However, what if the space now being used to produce the gear shifters could be used for another
purpose? If so, then the space would have an opportunity cost equal to the segment margin that would
come from the best alternative space.

If the space now being used for shifters, could be used to produce a new cross-country bike that would
generate a segment margin of $60,000, the cost analysis now looks like the following:

This opportunity cost now changes our decision to purchase from outside supplier.

Decision on Special Orders

Special order one-time order that is not considered part of the companys normal ongoing business.

Police department wants Mountain Goat Cycles to produce a special order of 100 bikes at $558 each.
Mountain Goat could modify a current model, the City Cruiser bike which sells for $698 and product cost
is $564, broken out on next page.
Variable portion of Manufacturing Overhead is $12 per unit. The special order has no effect on the
companys total fixed OH costs. Modifications to police order would cost $34 per bike and a fixed cost
to produce a stencil would be $2,400.

Calculate the incremental net operating income:

Since incremental revenue exceeds the incremental costs, Mountain Goat should accept the special
order.

Constraint anything that prevents you from getting more of what you want.
- Airline has limited # of gates available at airports they land at
o Constraint is loading gates
- Constraint, or bottleneck, is determined by the step that limits total output due to smallest capacity

Example National Health Service government-funded provider of health care in the UK


The step that has the smallest capacity is Surgery, so Surgery is the constraint.
- Dont place a greater strain on the system than the weakest link can handle, otherwise the chain
will break.
- Improve efforts on strengthening the constraint or bottleneck

Capacity of a bottleneck can be increased in a number of ways:


- Working overtime on the bottleneck
- Subcontracting some of the processing that would be done at the bottleneck
- Investing in additional machines
- Shifting workers from processes that are not bottlenecks to the process that is the bottleneck
- Focusing business process improvement efforts on the bottleneck

Joint Product Costs


Joint product two or more products that are produced from a common input
Split-off point the point in the manufacturing process at which the joint products can be recognized as
separate products.
Joint Cost common costs incurred up to the split-off point
- Allocated among the different products at the split-off point based on the relative sales value of the
end products
Decision to Sell or Process Further

Sell or process further decisions is it profitable to continue processing a joint product after the split-off
point?
- As long as the incremental revenue from such processing exceeds the incremental processing cost
incurred after the split-off point.
o Joint costs that have already been incurred up to the split-off point are always irrelevant in
decisions concerning what to do from the split-off point forward

**Company should sell the un-dyed Coarse Wool and not process further, but should process the Fine
and Superfine Wool further.

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