Question

Continuing with the company selected in Unit 2, think about the types of financial data that would be included and excluded in differential analysis. Propose which specific revenues and costs should be considered in an evaluation to drop or keep a:

• Customer
• Product line

In addition, explain sunk and opportunity costs as they relate to your selected company. Should these costs be considered in differential analysis? Why or why not?

1. The Cement Manufacturing Company sells cements to specialist industries. It sold $20,000 worth of cements in its most recent period with variable costs of $8,000. The Cement Manufacturing Company has fixed expenses of $13,000, resulting in a loss of $1000.

Revenue $20,000
Variable expenses $8,000
Contribution margin = Sales – Variable Costs = $12000
Fixed expenses $13,000
Net loss $1000

CM ratio/ Percentage = (Sales - Variable expenses)/Sales

= (20000 – 8000)/ 20000 x 100

= 60%

Cement Manufacturing Company Details (Hypothetical Values as required in the question)
Assumptions
Particular	Amount ($)
Sales	20000
Less variable Costs
Direct Material	5000
Direct Labor	3000
Contribution Margin (CM)	12000

Answer 1

Part 1 of the question :

Analyzing the differences between the current cost and revenues and the relevant/incremental costs and revenues due to various alternatives is what we call a "differential analysis".

The following costs and revenues are relevant in a decisions to keep a product line or customer :

1. Incremental revenue from alternative/order : Extra sales arising from taking the order

2. Variable Costs : Variable costs are always relevant as they vary with the level of production.

3. Avoidable Fixed Costs : If certain fixed costs exist which although do not vary with the level of production but could be avoided altogether if a particular product line or customer is discontinued or could be avoided by not taking a special order is relevant for our decision making.

4. Semi-Fixed Costs : These are also relevant as orders from new customers may increase the production above a certain level due to which additional cost might have to be incurred.

Part 2 of the question : Whether sunk and opportunity cost should be considered :

1. Sunk Cost : It refers to a cost which has already been incurred and can now no longer be reversed. It is not relevant for decision making and hence it should not form part of the differential analysis because it is a cost incurred in the past and acceptance of a new order or product line will have no effect on it.

2. Opportunity cost : It refers to the cost of choosing from alternatives. It is very much relevant for our decision making and is included in the differential analysis because it represents the profit/money that could have been earned with the resources available had they been invested in another alternative. That means we are letting go of that profit by choosing this particular alternative and hence it is relevant for us.

Example using the data available in the question :

Let's say Cement manufacturing company is considering accepting a new customer who plans on ordering 200 units @ 500$ each. However it requires expansion of space in the factory costing around 5,000$.

Hence we can make the following observations :

1. This expansion cost becomes an avoidable fixed cost as if we do not accept the order, we will not be incurring this cost. It becomes relevant for our differential analysis.

2. The incremental revenue arising from the above order = 200 units*500$ each = 10,000$

3. Incremental profit arising from special order = 10,000$ * 60% (Contribution margin ratio) = 6,000$

4. Actual profit from the new order = Incremental profit - Avoidable fixed costs = 6,000$ - 5,000$ = 1,000$

5. Hence Cement manufacturing company should accept this order as it provides the company a profit of 1,000$.

Note : Since fixed expenses being incurred by the company of 13,000$ are sunk cost, they have not been considered in the differential analysis.