Unit 5: Differential Analysis
In this unit, we examine how manufacturers decide whether to outsource elements of their operation. This decision process requires making a differential analysis to determine the revenues and costs for alternative courses of action. To do this, we will use the contribution margin income statement format. We will examine 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:
- describe the purpose of differential analysis;
- use differential analysis for make-or-buy decisions;
- use differential analysis for product line decisions;
- use differential analysis to decide whether to keep or drop customers;
- use differential analysis for special order decisions;
- define cost terms used in differential analysis;
- describe how to use cost-plus pricing and target costing to establish prices; and
- evaluate qualitative factors when using differential analysis.
5.1: Using Differential Analysis to Make Decisions
Read the introduction to Chapter 7 and section 7.1. The company, Best Boards, uses differential revenues and costs to show the difference in revenues and costs among alternative courses of action. Differential analysis helps make managerial decisions related to making or buying products, keeping or dropping product lines, keeping or dropping customers, and accepting or rejecting special customer orders. Soon, we will examine each of these four scenarios where differential analysis can be used.
Watch this video, which lays out the relevant costs for decision-making and defines some of the terms used in the rest of this series. Sunk costs are not relevant to decision-making, but differential costs (different costs between alternatives) are relevant.
This page outlines some of the important terms used in differential analysis.
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 are typically not eliminated if a product line is eliminated and are not differential costs. Managers compare sales revenue and costs for each alternative (keep or drop) and select the alternative with the highest profit.
This video goes over the case of Jen's Sweaters, which has been experiencing losses and is considering eliminating a product line.
Best Boards' decision is whether 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 differences between the alternatives are with costs (as in the make-or-buy decision for Best Boards), decision-makers will 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.
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 product lines.
Tony's T-shirts makes shirts for local sports teams. 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.
Kaatz is the only producer of Ting. Kaatz has received a special order for 5000 units. How can Kaatz make a sound financial decision? This video explores these questions.
5.2: 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.
5.3: Be Aware of Qualitative Factors
Although accountants are responsible for providing relevant and objective financial information to help managers make decisions, qualitative factors also play a significant role in the decision-making process.
Unit 5 Assessment
Take this assessment to see how well you understood this unit.
- This assessment does not count towards your grade. It is just for practice!
- You will see the correct answers when you submit your answers. Use this to help you study for the final exam!
- You can take this assessment as many times as you want, whenever you want.
Unit 5 Conclusion
This unit demonstrated how differential analysis can assist with many management decisions. Differential analysis builds on the contribution margin income statement. We also looked at two other costing strategies, cost-plus and target costs; both have their place in the managerial toolbox. In the next unit, you will delve into the why and how of master budgets.