9 3: Applying Differential Analysis in Managerial Decision Making Business LibreTexts

Because enough idle capacity exists to handle this order, it will not affect other sales. That is, Tony has the factory space and machinery available to produce more T-shirts. One aspect that companies must be aware of is the potential for cost assumptions to be wrong. Every effort must ach transfer be made to make correct cost estimates so that the choice of an opportunity that a business ultimately makes doesn’t affect the company negatively. Incremental analysis is a problem-solving method that applies accounting information—with a focus on costs—to strategic decision-making.

2: Using Differential Analysis to Make Decisions

They are the extra expenses encountered by choosing one course of action over another. (ii) It is profitable for the company to increase the level of production so long as the incremental revenue is more than the differential costs. It is not advisable to increase the level of production to such a level where the differential costs are more than the incremental revenue. In the given problem, the company should set the level of production at 1,50,000 units because after this level differential costs exceed the incremental revenue. If companies add or eliminate products, theyusually increase or decrease variable costs. Management bases decisions to add oreliminate products only on the differential items; that is, thecosts and revenues that change.

What Is the Benefit of Incremental Analysis?

The cost of rent for the building is considered a common fixed cost since both departments exist in the same building. The cost for rent would not be eliminated if one of the departments is eliminated. Since the cost of rent is unavoidable regardless of what segments are housed within the building, it is not considered relevant to a decision about one of the segments. Sunk costs are costs that have already been incurred and, therefore, cannot be avoided.

1. Relevant costs or benefits are defined as costs or benefits that differ between alternatives.
2. Carlos collected the data, presented below, related to the cost of making the compost on the farm.
3. Annual capacity is 10,000 units, and annual fixed costs total $48,000.
4. They are essential in assisting businesses with various decision-making processes, from pricing, product discontinuation, and manufacturing to resource allocation and strategic planning.
5. The previous section focuses on using differential analysis to assess pricing for special orders.
6. Marginal analysis usually disregards any past or sunk cost, and it is useful when working on a business strategy such as to outsource a function or self-produce it.

Video Illustration 10-1: Add or drop a segment LO3

Or, Healthy farms can process the bran into a fiber supplement that sells for $3.00 per pound for an additional $4,200 in processing and packaging costs. And they can process the germ meal into a health food https://www.business-accounting.net/ supplement that sells for $2.75 per pound for an additional $4,700 in processing and packaging costs. Healthy Farms operates a small family farm that specializes in growing organic, non-GMO produce.

Product Portfolio Management

If the desired target cost cannot be achieved, the company must go back to step 1 and reevaluate the features and price. The following monthly financial data are for Quicko’s, a company that makes photocopies for its customers. Incremental analysis only focuses on the differences between particular courses of action. These differences—not the similarities—form the basis of the analysis comparison. A Statement of Differential Cost and Revenue is prepared to perform differential costing. Among several alternatives, management opts for the most profitable one.

Carefully examine Figure 4.5 “Income Statement for Barbeque Company”. Notice that the charcoal barbecues product line shows a loss of $8,000 for the year. This is the reason management would like to consider dropping this product line. Relevant costs (also called incremental costs) are incurred only when a particular activity has been initiated or increased. To fully comprehend the concept of incremental analysis, one has to understand its underlying concepts. The three main concepts are relevant cost, sunk cost, and opportunity cost.

Negative amounts appearing in the Differential Amount column indicate Alternative 1 is lower than Alternative 2. The fourth column shows whether Alternative 1 is higher or lower than Alternative 2 for each line item. If no excess capacity is present, additional expenses to consider include investment in new fixed assets, overtime labor costs, and the opportunity cost of lost sales. The concept of relevant cost describes the costs and revenues that vary among respective alternatives and do not include revenues and costs that are common between alternatives.

Overheads are variable to the extent of 25 per cent of the present amount. 3.) Building and maintenance represent the expenses related to the salon property including rent, insurance, and deprecation. None of these costs would be eliminated if the nails product line was dropped.

The revenues that are generated between different alternatives are referred to as relevant benefits in some studies or texts. Notice that in Figure 7.1 the columns labeled Alternative 1 and Alternative 2 show revenues, costs, and profit for each alternative. Differential cost is the variation in costs (increase/decrease) between two available opportunities.

For instance, a company can evaluate the unique costs involved with expansion and contrast them with prospective revenues when considering expanding into new regions. By being aware of the incremental costs of each alternative, organizations can better invest resources where they will provide the greatest value. Differential costs are a key idea in the fields of business and economics. Suppose Nike, Inc., has developed a new shoe that can be sold for $140 a pair.

The manager collected the additional information presented below to aid in making this decision. Per the data, $15,025 of the selling and administration expenses are traceable to the shiitake product line. Shrooms would save $15,025 in fixed selling and administration expenses. Sometimes management has an opportunity to sell its product in two or more markets at two or more different prices.