7 2 Using Differential Analysis to Make Decisions Cost Accounting

This new department would contribute $35,000 to the bookstore’s income. Quicko’s is approached by a local restaurant that would like to have 20,000 flyers copied. The restaurant asks Quicko’s to semimonthly vs biweekly produce the flyers for 7 cents a copy rather than the standard price of 8 cents. Quicko’s can produce up to 130,000 copies a month, so the special order will not affect regular customer sales.

  1. The company should not process product B further because that would decrease income by $1 per unit sold.
  2. The long-run incremental cost for lithium, nickel, cobalt, and graphite as critical raw materials for making electric vehicles are a good example.
  3. When business executives face such situations, they must select the most viable option by comparing the costs and profits of each option.
  4. That is, regular customers may hear of this special price and demand the same price, particularly those customers who have been loyal to Tony’s T-shirts for many years.

To illustrate, assume Rios Company produces and sells a single product with a variable cost of $8 per unit. The selling price is $20 per unit and production and sales are budgeted at 5,000 units. Incremental cost is the total cost incurred due to an additional unit of product being produced. Incremental cost is calculated by analyzing the additional expenses involved in the production process, such as raw materials, for one additional unit of production. Understanding incremental costs can help companies boost production efficiency and profitability.

Particularly in sectors with fluctuating production costs, these expenses are frequently considered’ while making short-term decisions. They assist businesses in determining which financial option is the best one among various alternatives. Because the special order does not increase the fixed costs, the special order’s revenues need only cover its variable costs.

Deciding how much to charge for goods or services is an essential choice for any organization. Differential costs, sometimes called incremental, are the overall costs incurred while choosing between several options. Management’s goal is to loosen the constraint by providing more labor hours to department 4. For example, management may decide to move employees from departments 1, 2, and 3 to the quality testing department. Another option is to authorize overtime for the workers in department 4. Perhaps management will consider hiring additional workers for department 4.

Activity-based costing first assigns costs to activities and then to products or customers based on their use of the activities. Activity-based costing is a refined approach to allocating costs https://www.wave-accounting.net/ to products or customers. A sunk cost is a cost incurred in the past that cannot be changed by future decisions. And panel C presents the differential analysis for the two alternatives.

5 Review of Cost Terms Used in Differential Analysis

It is usually calculated when the company produces enough output to cover fixed costs, and production is past the breakeven point where all costs going forward are variable. However, incremental cost refers to the additional cost related to the decision to increase output. Alternatively, once incremental costs exceed incremental revenue for a unit, the company takes a loss for each item produced. Therefore, knowing the incremental cost of additional units of production and comparing it to the selling price of these goods assists in meeting profit goals. The difference in total costs between two or more alternative courses of action is known as differential costs, often called incremental costs. They are the extra expenses encountered by choosing one course of action over another.

For example, rent paid for Barbeque Company’s retail store is allocated to all three product lines because it is not easily traced to each product line. However, the retail store rent likely will not decrease if the charcoal barbecues product line is eliminated (unless the company chooses to move to a smaller, less costly store). The charcoal barbecues’ allocation for rent would simply be reallocated to the other two products. Thus rent for the retail store is an example of an allocated fixed cost that is not a differential cost for the two alternatives facing Barbeque Company.

Although fixed and variable costs are not forms of differential costs in and of themselves, it is crucial to distinguish between the two when performing differential cost analysis. In make-or-buy decisions, management also should consider the opportunity cost of not utilizing the space for some other purpose. Thus 75 percent of all allocated fixed costs are assigned to that product line.

What Is the Benefit of Incremental Analysis?

If the telecom operator adopts the new advertisement techniques, they will spend $2,000 per month in advertising expenses. It assists in determining how profitable these choices will be in the long run. Organizations can better invest resources where they will provide the greatest value by being aware of the incremental costs of each alternative. Consider the scenario when a business decides to fund Project A rather than Project B using its resources.

Chapter 10: Differential Analysis (or Relevant Costs)

Based on the calculations shown in the table below, the company should select a price of $8 per unit because choice (3) results in the greatest total contribution margin and net income. In the short run, maximizing total contribution margin maximizes profits. 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).

Relevant Versus Non-Relevant Costs

Good business management requires keeping the cost of idleness at a minimum. When operating at less than full capacity, management should seek additional business. Management may decide to accept such additional business at prices lower than average unit costs if the differential revenues from the additional business exceed the differential costs. By accepting special orders at a discount, businesses can keep people employed that they would otherwise lay off. If a company sets a high price, the number of units sold may decline substantially as customers switch to lower-priced competitive products. Thus, in the maximization of income, the expected volume of sales at each price is as important as the contribution margin per unit of product sold.

Discontinuing a product to avoid the losses and increase profits – decision to drop a product line. Differential costing involves the study of difference in costs between two alternatives and hence it is the study of these differences, and not the absolute items of cost, which is important. Moreover, elements of cost which remain the same or identical for the alternatives are not taken into consideration.

Businesses frequently have to determine whether to keep making or offering a specific good or service. The analysis helps determine if it would be financially viable to stop producing a product or whether changes could make it more profitable. Companies frequently experience resource limitations due to a lack of funds, labor, or materials. Resource allocation can be optimized with the use of differential cost analysis. For instance, if a business has previously paid for research and development on a product, that expense is seen as sunk and shouldn’t be considered when making future decisions.

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. 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.

Company executives must choose between options, but the decision should be made after considering the opportunity cost of not obtaining the benefits offered by the option not chosen. External costs are costs imposed on third parties or society as a whole, which are not accounted for by the business itself. These costs can include pollution, but they are not directly incurred by the business as a result of its decisions. Differential costs are a key idea in the fields of business and economics. Although these five decisions are not the only applications of differential analysis, they represent typical short-term business decisions using differential analysis. A significant advantage of using activity-based costing is having accurate data for decision-making purposes, particularly in the area of differential analysis.

The separation of fixed costs and variable costs and determination of raw material and labor costs also differs from organization to organization. Companies do not record opportunity costs in the accounting records because they are the costs of not following a certain alternative. Thus, opportunity costs are not transactions that occurred but that did not occur. However, opportunity cost is a relevant cost in many decisions because it represents a real sacrifice when one alternative is chosen instead of another. It’s important to note that businesses also consider other factors, such as market demand and competition, in addition to differential costs when making pricing and manufacturing decisions.

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