Unit 5: Differential Analysis
In this unit we examine how manufacturers decide whether 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 a 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 then click the link at the top right for "Next Section" to read Section 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 subunit, you will examine each of these four scenarios for which differential analysis can be used to assist managers' decision-making.
Watch this video, in which Tony Bell lays out the relevant costs for decision-making and defines some of the terms that he will use in the remainder of this series. Remember, sunk costs are not relevant to decision-making, but differential costs (different costs between alternatives) are relevant.
The important terms discussed in this unit are outlined here for your reference.
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.
Bell considers Jen’s Sweaters which has been experiencing losses and is considering eliminating a product line. Be sure to follow along in your notes.
Best Board's decisions 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 would select the alternative with the lowest cost.
In this video, Tony Bell 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.
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.
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.
Kaatz is the only producer of Ting. Kaatz has received a special order for 5000 units. How can Kaatz make a sound financial decision? Bell explores the thing about Ting and if Kaatz can.
5.2: Cost-Plus Pricing and Target Costing
In this section, you will explore other pricing systems and why companies may choose to 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 Conclusion
This unit has demonstrated how differential analysis can be used to assist with a myriad of management decisions. Differential analysis builds on the contribution margin income statement. Further costing strategies have also been provided, 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.