7 2: Using Differential Analysis to Make Decisions Business LibreTexts

Company executives use differential cost analysis to choose between options to make viable decisions to impact the company positively. The differential cost method is a managerial accounting process done on spreadsheets and requires no accounting entries. If the LRIC increases, it means a company will likely raise product prices to cover the costs; the opposite is also true. The calculation of incremental cost needs to be automated at every level of production to make decision-making more efficient. There is a need to prepare a spreadsheet that tracks costs and production output. As output rises, cost per unit decreases, and profitability increases.

For example, many companies may have to add increased capacity if they choose to create more units beyond a certain point. Thus 75 percent of all allocated fixed costs are assigned to that product line. The calculation of incremental cost shows a change in costs as production expands. Incremental cost is usually computed by manufacturing entities as a process in short-term decision-making.

What is Incremental Analysis?

Use differential analysis to decide whether to keep or drop customers. The original cost of this store equipment is a sunk cost and should have no bearing on the decision whether to eliminate charcoal barbecues. An opportunity cost is the benefit foregone when one alternative is selected over another.

• This includes both fixed costs, or costs incurred regardless of output, and variable costs, or those costs that can change depending on output.
• The differential cost method is a managerial accounting process done on spreadsheets and requires no accounting entries.
• Certain costs will be incurred whether there is an increase in production or not, which are not computed when determining incremental cost, and they include fixed costs.
• However, care must be exercised as allocation of fixed costs to total cost decreases as additional units are produced.

Relevant costs are also called incremental costs because they are only incurred when an activity of relevance has been increased or initiated. Direct fixed costs—fixed costs that can be traced directly to a product line or customer—are differential costs and therefore pertinent to making decisions. However, we must review these costs on a case-by-case basis because some direct fixed costs may not be considered differential in spite of being traced directly to a product line.

Incremental Revenue vs. Incremental Cost

Thus Computers, Inc., must try to move resources from other areas to department 4 to reduce the backlog of computers to be tested. If this product line is eliminated, the product line manager’s salary is also eliminated (unless the product line manager has a long-term employment contract). For example, the salary of the manager responsible for a product is easily traced to the product line. If you still have questions or prefer to get help directly from an agent, please submit a request. Access and download collection of free Templates to help power your productivity and performance. B One supervisor must be paid $90,000 per year even if the company buys the product.

Relevant costs should be considered before making a decision, not afterward. Thus, relevant costs are among the more important items that a business owner will examine with upcoming decisions. When calculating relevant costs, irrelevant costs must be carefully identified as not to confuse them with a relevant cost. For example, when deciding to purchase a necessary product for a business, adding any costs will increase overall expenses for this business decision. Companies will want to avoid mistakenly adding an irrelevant cost that incorrectly inflates relevant costs.

Concepts Incorporated Into Incremental Analysis

If Best Boards chooses to buy the product from an outside producer, the company avoids such costs as direct materials, direct labor, manufacturing overhead, and the salary of one supervisor. It’s worth noting that while differential cost is a key factor in such decisions, it’s not the only one. The company might also consider factors like quality control, speed of production, the reliability of the third-party manufacturer, and more.

A representative of the local high school recently approached Tony to ask about a one-time special order. The high school will be hosting a statewide track and field event and is willing to pay Tony’s T-shirts $17 per shirt to make 200 custom T-shirts for the event. 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. However, management may want a more concise explanation of why profit is $10,000 higher when all three product lines are maintained. Since a differential cost is only used for management decision making, there is no accounting entry for it.

What is the difference between a differential cost and an incremental cost?

Opportunity costs can also be included in the differential analysis format presented in Figure 4.6 “Product Line Differential Analysis for Barbeque Company”. Panel C of Figure 4.6 “Product Line Differential Analysis for Barbeque Company” is simply modified to reflect the opportunity cost, as shown. After all, the goal of differential analysis is to analyze the costs that differ from one alternative to the next. In the following case study, you will play the role of a consultant that will help a client of yours make an important strategic business decision.

The method incorporates accounting and financial information in the decision-making process and allows for the projection of outcomes for various alternatives and outcomes. Through incremental analysis, the revenues, costs, and possible outcomes of the alternatives can be identified. Notice that the columns labeled Alternative 1 and Alternative 2 show information in summary form (i.e., no detail is provided for revenues, variable costs, or fixed costs). Some managers may want only this type of summary information, whereas others may prefer more detailed information. It is important to be flexible with the format, to best meet the needs of managers. We will build upon the differential analysis format shown in Figure 7.1 throughout this chapter, and show how more detail can easily be provided using the same format.

Incremental analysis helps companies decide whether or not to accept a special order. Incremental analysis also assists with allocating limited resources to several product lines to ensure a scarce asset is used to maximum benefit. The management at Computers, Inc., has identified department 4, quality testing, as the bottleneck because assembled computers are backing up at department 4. Quality testing cannot be performed fast enough to keep up with the inflow of computers coming from departments 1, 2, and 3. A limitation of labor hours available to perform testing is causing this backlog. G  Analyzing the difference in revenues and costs from one alternative course of action to another.

Tony’s might be forced to lower prices for regular customers, thereby eroding the company’s profits over time. The key point is that companies evaluating special orders can drop prices in the short run to cover differential variable and fixed costs. Allocated fixed costs—fixed costs that cannot be traced directly to a product—are typically not differential costs. For example, master budget if a product line is eliminated, these costs are simply allocated to the remaining product lines. Analyzing production volumes and the incremental costs can help companies achieve economies of scale to optimize production. Economies of scale occurs when increasing production leads to lower costs since the costs are spread out over a larger number of goods being produced.

The other supervisor, who is paid $50,000 per year, can be let go if the company buys the product. Harold Averkamp https://online-accounting.net/ (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.

In other words, the average cost per unit declines as production increases. The fixed costs don’t usually change when incremental costs are added, meaning the cost of the equipment doesn’t fluctuate with production volumes. Differential costs are typically variable costs, meaning they can change based on the volume of output or other activity levels.

What is Variable Interest Entity?

If the telecom operator adopts the new advertisement techniques, they will spend $2,000 per month in advertising expenses. Businesses use differential cost analysis to make critical decisions on long-term and short-term projects. Differential cost also provides managers quantitative analysis that forms the basis for developing company strategies. Differential cost refers to the difference between the cost of two alternative decisions. The cost occurs when a business faces several similar options, and a choice must be made by picking one option and dropping the other. When business executives face such situations, they must select the most viable option by comparing the costs and profits of each option.

Differential revenues and costs (also called relevant revenues and costs or incremental revenues and costs) represent the difference in revenues and costs among alternative courses of action. Sunk costs refer to costs that a business has already incurred, but that cannot be eliminated by any management decision. An example is when a company purchases a machine that becomes obsolete within a short period of time, and the products produced by the machine can no longer be sold to customers. Differential cost may be a fixed cost, variable cost, or a combination of both.