Using Differential Analysis to Make Decisions

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. 

Analyzing this difference is called differential analysis (or incremental analysis). 

The general rule is to select the alternative with the highest differential profit. 

Avoidable and Unavoidable Costs in Differential Analysis

Differential analysis requires that we consider all differential revenues and costs—costs that differ from one alternative to another—when deciding between alternative courses of action. 

Avoidable costs—costs that can be avoided by selecting a particular course of action— are always differential costs and must be considered when deciding between alternative courses of action.

• Note: Amounts shown in parentheses indicate a negative impact on profit, and amounts without parentheses indicate a positive impact on profit.

Opportunity costs—the benefits foregone when one alternative is selected over another—are differential costs, and must be included when performing differential analysis. 

Sunk costs—costs incurred in the past that cannot be changed by future decisions—are not differential costs because they cannot be changed by future decisions.

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. 

For example, a five-year lease on a warehouse used solely for one product line is a direct fixed cost but not a differential cost because the costs will continue even if the product line is eliminated.

Allocated fixed costs—fixed costs that cannot be traced directly to a product—are typically not differential costs. 

For example, if a product line is eliminated, these costs are simply allocated to the remaining product lines.

We can  differential analysis to assist in making the following types of decisions:

• Make or buy products
• Keep or drop product lines
• Keep or drop customers
• Accept or reject special customer orders

Product Line Decisions

A product line is a group of related products. 

Companies must continually assess whether they should add new product lines, and whether they should discontinue current product lines. 

Differential analysis provides a format for these types of decisions. 

How would differential analysis be used to make a product line decision?

Company would like to consider two alternatives. 

Alternative 1 is to retain all three product lines, and Alternative 2 is to eliminate the a specific product line. 

The variable costs are related directly to each product line, and thus are eliminated if the product line is eliminated. 

That is, all variable costs are differential costs for the two alternatives facing the Company.

Notice that two lines appear for fixed costs: direct fixed costs and allocated fixed costs. 

What is the difference between direct fixed costs and allocated fixed costs?

Direct fixed costs are fixed costs that can be traced directly to a product line. 

Direct fixed costs are often differential costs. 

For example, the salary of the manager responsible for a product is easily traced to the product line. 

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).

Allocated fixed costs (also called common fixed costs) are fixed costs that cannot be traced directly to a product line, and therefore are assigned to product lines using an allocation process. 

Allocated fixed costs are typically not differential costs. 

Rent for the retail store is an example of an allocated fixed cost that is not a differential cost for the two alternatives facing the Company.

How are a Company’s allocated fixed costs assigned to individual product lines?

Company’s total allocated fixed costs are allocated based on sales. 

Sales revenue for Product 1 is 75 percent of total company sales. Thus 75 percent of all allocated fixed costs are assigned to that product line. 

Will dropping a product line result in higher company profit?

Panel A shows the income statement for Alternative 1: keeping all three product lines. 

Panel B shows the income statement for Alternative 2: dropping the charcoal barbecues product line. 

And panel C presents the differential analysis for the two alternatives. The differential analysis in panel C shows that overall profit will decrease by $10,000 if the charcoal barbecue product line is dropped. 

However, management may want a more concise explanation of why profit is $10,000 higher when all three product lines are maintained. 

Company will lose sales revenue of $90,000 if it drops the charcoal barbecues product line. However, it saves variable costs of $40,000 and direct fixed costs of $40,000 if it drops the charcoal barbecues product line. Because the $80,000 in cost savings is not enough to make up for the $90,000 loss in sales revenue, profit will decline by $10,000 (= $80,000 − $90,000).

Misleading Allocation of Fixed Costs

How can a product line show a loss while the company as a whole is better off keeping this product line?

Allocated costs are typically not differential costs, and therefore are typically not relevant to the decision.

Including Opportunity Costs in Differential Analysis

Managers must often consider the impact of opportunity costs when making decisions.

An opportunity cost is the benefit foregone when one alternative is selected over another. 

Opportunity costs can also be included in the differential analysis format.

Sunk Costs and Differential Analysis

A sunk cost is a cost incurred in the past that cannot be changed by future decisions. 

The original cost of this store equipment is a sunk cost and should have no bearing on the decision whether to eliminate charcoal barbecues. 

As a general rule, sunk costs are not differential costs.

Customer Decisions

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

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.

How does the differential analysis format differ for customer decisions compared to product line decisions?

Instead of tracing revenues, variable costs, and fixed costs directly to product lines, we track this information by customer. 

Fixed costs that cannot be traced directly to customers are allocated to customers. Let’s identify the similarities and differences between the two formats.

Thus allocated fixed costs are not differential costs. 

Using Activity-Based Costing to Assess Customer Profitability

Activity-based costing is a refined approach to allocating costs to products or customers. 

Activity-based costing first assigns costs to activities and then to products or customers based on their use of the activities. 

The cost information provided by activity-based costing is generally regarded as more accurate than most traditional costing methods. 

When assessing customer profitability, costs can be assigned to customers based on each customer’s use of activities. 

Customer costs are measurable across four categories of activities:

• Cost to acquire customers: Consists of activities such as advertising and promotional materials.
• Cost to provide goods and services: Consists of activities such as processing customer orders and delivering goods.
• Cost to serve customers: Consists of activities such as technical support and processing customer payments.
• Cost to retain customers: Consists of activities such as offering discounts and building relationships.

With the help of activity-based costing, costs can be assigned to activities within each category. 

These costs are then allocated to customers based on each customer’s use of activities. 

A significant advantage of using activity-based costing is having accurate data for decision-making purposes, particularly in the area of differential analysis.

Qualitative Factors in Differential Analysis

This chapter has focused on using relevant revenue and cost information to perform differential analysis. 

Using these quantitative factors to make decisions allows managers to support decisions with measurable data. 

Although using quantitative factors for decision making is important, management must also consider qualitative factors. 

Related Topics

• Job Costing vs Process Costing
• Assign Direct Material and Direct Labor to Job
• Assign Manufacturing Overhead Costs to Job
• Assign Overhead Costs to Products
• Plantwide Cost Allocation
• Department Cost Allocation
• Activity-Based Costing
• Weighted-Average Cost of Products
• Production Cost Report
• Fixed, Variable, and Mixed Cost Estimations
• Contribution Margin Income Statement
• Cost-Volume-Profit Analysis
• Margin of Safety
• Contribution Margin per Unit of Constraint
• Absorption Costing vs Variable Costing
• Differential Analysis and Decisions
• Cost Decisions for Joint Products
• Capital Budgeting
• Life Cycle Costing
• The Master Budget
• Activity-Based Budgeting
• Standard Costs
• Imputed Value
• Variance Analysis for Product Costs
• Absorption Pricing
• Price Variance
• Absorption Variance 
• Responsibility Centers
• Comparing Segmented Income
• Using ROI to Evaluate Performance
• Using Residual Income to Evaluate Performance
• Use Economic Value Added to Evaluate Performance
• Transfer Pricing