Unit 6: Using Differential Analysis to Make Decisions
In this unit we examine how manufacturers decide whether or not to outsource elements of their operation, a decision process that requires making a differential analysis to determine the revenues and costs for alternative courses of action. As you work
through this unit, notice you will use the contribution margin income statement format. We will examine both relatively simple and more complex examples to establish the format used to perform differential analysis.
Completing this unit should take you approximately 4 hours.
Upon successful completion of this unit, you will be able to:
- use differential analysis for make-or-buy, product line, and special order decisions;
- use differential analysis to decide whether to keep or drop customers; and
- use cost-plus pricing and target costing to establish prices.
6.1: Formatting differential analysis
Read the Chapter 7 introduction, then click "Next Section" to read Section 7.1. Best Boards will use differential revenues and costs to show the difference in revenues and costs among alternative courses of action. Differential analysis is useful in making managerial decisions related to making or buying products, keeping or dropping product lines, keeping or dropping customers, and accepting or rejecting special customer orders. Later in this unit, you will examine each of these four scenarios for which differential analysis can be used to assist managers' decision-making.
6.2: Make-or-Buy Decisions
Read section 7.2. Best Board's decision is whether or not to make its own wakeboards or buy them from a supplier. Differential analysis requires the identification of all revenues and costs that differ from one alternative to another. In general, managers select the alternative with the highest profit. If the only difference between the alternatives is cost (as in the make-or-buy decision for Best Boards), decision-makers would select the alternative with the lowest cost.
This video examines a make-or-buy decision that Snazzy Jazzi Footwear is trying to make and how differential analysis can be used to assist with that snappy decision.
6.3: Product Line Decisions
Managers often use differential analysis to determine whether to keep or drop a product line. Direct fixed costs are typically eliminated if a product line is eliminated and are, therefore, considered differential costs. Allocated fixed costs, however, are typically not eliminated if a product line is eliminated. Managers compare sales revenue and costs for each alternative (keep or drop) and select the alternative with the highest profit. Read section 7.3. to learn more.
This video considers Jen's Sweaters, which has been experiencing losses and is considering eliminating a product line. Be sure to follow along in your notes.
6.4: Customer Decisions
Read section 7.4. 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.
6.5: Special Order
Before learning about special orders in the next section, let's do a quick review of the terminology!
Tony's T-shirts makes shirts for local sports teams, and occasionally Tony will receive special orders that involve additional costs. How does Tony go about deciding whether or not to accept these special orders? Managers often use differential analysis to decide whether to accept a special one-time order made by a customer. Managers compare sales revenue and costs for each alternative (accept or reject the special order) and select the alternative with the highest profit. Organizations must be careful to consider the long-run implications of reducing prices for special orders. Read section 7.6 to learn more.
Kaatz is the only producer of Ting. Kaatz has received a special order for 5,000 units. How can Kaatz make a sound financial decision? Watch the video to find out!
6.6: Cost-Plus Pricing and Target Costing
In this section, you will explore other pricing systems and why companies may use them. Cost-plus pricing starts with an estimate of the costs incurred to build a product, and a certain profit percentage is added to establish the price. Companies often use this method when it is difficult to determine a reasonable market price. Target costing integrates the product design, desired price, desired profit, and desired cost into one process beginning at the product development stage.