CHAPTER 12 DIFFERENTIAL ANALYSIS THE KEY TO DECISION MAKING L1 Identify relevant and irrelevant costs and benefits in a decision L2 Prepare an analysis showing whether a product line business segment should be added or dropped L3 Prepare a make or buy analysis L4 Prepare an analysis showing whether a special order should be accepted L5 Determine the most profitable use of a constrained resource L6 Determine the value of obtaining more of the constrained resource L7 Prepare an analysis showing whether joint products should be sold at the split off point or processed further In making a decision the cost and benefits of one alternative must be compared to the costs and benefits of other alternatives Differential analysis makes these comparisons Relevant Costs Costs that differ between alternatives Relevant Benefits Distinguishing between relevant and irrelevant costs benefits is critical because first irrelevant data can be ignored saving decision makers tremendous amounts of time and effort Second bad decisions can easily result from erroneously including irrelevant costs and benefits when analyzing alternatives I COST CONCEPTS FOR DECISION MAKING a Identifying Relevant Costs and Benefits i Only those costs benefits that differ in total between ii alternatives are relevant in a decision If the total amount of a cost will be the same regardless of the alternative selected then the decision has no effect on the cost so the cost can be ignored iii Avoidable Cost a cost that can be eliminated by choosing one alternative over the other 1 Avoidable Costs are Relevant Costs 2 Unavoidable costs are Irrelevant Costs because will be charged either way a Sunk Cost cost that has already been incurred and cannot be avoided regardless of what a manager decides to do b Future Costs that do not differ between the alternatives Hasn t yet been incurred c Both will always the same no matter what alternatives are being considered therefore they are irrelevant and should be ignored when making decisions iv Only those costs benefits that differ between alternatives are relevant in a decision and are often called avoidable costs v Key to successful decision making is to focus on just these relevant costs benefits and to ignore everything else b Different Costs for Different Purposes i Costs that are relevant in one decision situation are not necessarily relevant in another ii Managers need different costs for different purposes 1 For one purpose particular group of costs may be relevant 2 Each decision situation must be carefully analyzed to isolate the relevant costs 3 Remember irrelevant data may cloud the situation and lead to a bad decision c An Example of Identifying Relevant Costs and Benefits d Reconciling the Total and Differential Approaches i Including all of the costs benefits relevant or not will still get you the correct answer because the irrelevant costs and benefits will cancel out when alternatives are compared BUT could have arrived at same solution much more quickly by completely ignoring the irrelevant costs and benefits ii Differential Costs and Benefits column the difference iii Differential Costs and Benefits column the difference favors the new situation favors the current situation iv 0 Differential Costs and Benefits Column total amount for new item is exactly the same for both e Why Isolate Relevant Costs i Only rarely will enough information be available to prepared a detailed income statement for both alternatives 1 Must accurately recognize which costs are relevant and which are not in order to assemble the data necessary to make a decision ii Mingling irrelevant costs with relevant costs may cause confusion and distract attention from the information that is really critical II ADDING AND DROPPING PRODUCT LINES AND OTHER SEGMENTS Utilizing a final decision to drop a business segment or add a new one hinges primarily on the impact the decision will have on net operating income a Illustration of Cost Analysis 1 Must first recognize that what it seems is not always what it is fixed expenses that can be avoided are not distinguished nor are common fixed expenses that cannot be avoided ii The costs that differ between keeping dropping a segment alternative that can be avoided by dropping the product line are relevant 1 Step 1 Compute Current Net Income a 2 Step 2 Define avoidable vs unavoidable costs Total up Avoidable costs a b 3 Step 3 Subtract Avoidable costs from the Contribution Margin lost that would have been to find Dec Inc in overall company net operating income a AKA Compare fixed costs that can be avoided by dropping the housewares product line to the contribution margin that will be lost iii iv If dropping segment enables company to avoid more in fixed costs than it loses in contribution margin then its overall net operating income will improve by eliminating the product line If company is not able to avoid as much in fixed costs as it loses in contribution margin the segment should be kept 1 Must figure out which costs are avoidable and which are not then make table comparing both alternatives b Comparative Format i Format that includes Comparative income statements showing the effects of either keeping or dropping the product line 1 c Beware of Allocated Fixed Costs i Why Keep A Product line that is showing loss ii Explanation lies in part with the common fixed costs that are being allocated to the product lines 1 One of the greatest dangers in allocating common fixed costs is that such allocations can make a product line or other business segment look less profitable than it really is 2 Only way to find out if this is true is if you eliminate the allocation of the common fixed cost by using the segmented approach to estimate the profitability of product lines Chapter 6 a III iii Managers may choose to retain an unprofitable product line if the line helps sell other products or if it serves as a magnet to attract customers THE MAKE OR BUY DECISION Value Chain All activities from development to production to after sales services Vertically Integrated When a company is involved in more than one activity in the entire value chain Make or Buy Decision A decision to carry out one of the activities in the value chain internally rather than to buy externally from a supplier a Strategic Aspects of the Make or Buy Decision i Vertical Integration provides certain advantages 1 Less dependent on its suppliers and may be able to ensure a smoother flow of parts and materials
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