BUS105 Study Guide

Unit 6: Using Differential Analysis to Make Decisions

6a. Use differential analysis for make-or-buy, product line, and special order decisions

  • How can cost information be used in managerial decision-making?
  • When considering two or more alternative courses of action, why is it important to use differential analysis?
  • Why are fixed costs generally excluded from differential analysis?

The idea of differential analysis is that when faced with two or more alternatives, we only look at and compare the differences in revenue and expenses associated with each option. Any costs that are common to every alternative can be ignored. For a make or buy decision, a decision to keep or drop a product line, or a decision about whether or not to accept a special order, we will only look at the incremental changes in variable costs as well as the changes in revenue for each alternative. In each of these cases, fixed costs will not change (provided we are within the relevant range) and can therefore be ignored.

Review Make-or-Buy Decisions, Product Line Decisions, and Special Order Decisions.

6b. Use differential analysis to decide whether to keep or drop customers

  • Why may a firm decide that it may be worth dropping a customer?
  • When making a determination whether or not to drop a customer, which costs should be traced to the customer?
  • How are fixed costs traced to individual customers?

If a company feels that a customer may be costing more than the revenue brought to it by that customer, they can use differential analysis to determine whether to keep or drop that customer. The method for doing this is similar to the format used for making product line decisions except that in this case, sales revenue, variable costs, and fixed costs are traced directly to customers rather than to product lines. Since fixed costs are not directly traceable to specific customers, they must be allocated among all the customers. Thus, although dropping a customer will eliminate variable costs associated with that customer, such as cost of goods sold, shipping, maintenance, and support, the fixed costs will continue but their allocation will be shifted to another customer. 

Review Customer Decisions, especially Figure 7.10, for an example of keep or drop analysis. 

6c. Use cost-plus pricing and target costing to establish prices

  • What methods are used to determine selling prices?
  • Which costs should be included when calculating cost-plus pricing?
  • What are the four steps involved in target costing?

Aside from differential analysis, there are two other methods used to establish selling prices. Cost-plus pricing begins with an estimate of what costs will be incurred to produce a certain product or provide a certain service. Then, the manufacturer will determine a percent markup required for profit above the cost. This then becomes the selling price. Care must be taken to ascertain which costs are to be included when calculating cost-plus pricing.

Target costing is a costing method that involves a four-step process to determine a selling price and product cost. Here, a firm starts with the price customers are willing to pay and needs to engineer the product in a way where the costs are low enough to produce the desired profit. 

Review Cost-Plus Pricing and Target Costing.

Unit 6 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • cost-plus pricing
  • differential analysis 
  • keep or drop a customer decision
  • keep or drop a product line decision
  • make or buy decision
  • special order
  • target costing