Question

5. How is differential analysis used in deciding whether to keep or drop product lines?

6. Why are direct fixed costs typically differential costs?

7. Why are allocated fixed costs typically not differential costs?

8. What is an opportunity cost? Why is an opportunity cost a differential cost?

9. How is differential analysis similar for customer decisions and product line decisions?

10. What two important assumptions must be considered when evaluating special order scenarios?

Answer 1

5 - How is differential analysis used in deciding whether to keep or drop product lines?

A decision whether or not to continue an old product line or department, or to start a new one is called an add-or-drop decision. An add-or-drop decision must be based only on relevant information.

Relevant information includes the revenues and costs which are directly related to a product line or department. Examples of relevant information are sales revenue, direct costs, variable overhead and direct fixed overhead. Such decision must not be based on irrelevant information such as allocated fixed overhead because allocated fixed overhead will not be eliminated if the product line or department is dropped.

The following example illustrates an add-or-drop decision:

Example

A company has three products: Product A, Product B and Product C. Income statements of the three product lines for the latest month are given below:

Product Line	A	B	C
Sales	$467,000	$314,000	$598,000
Variable Costs	241,000	169,000	321,000
Contribution Margin	$226,000	$145,000	$277,000
Direct Fixed Costs	91,000	86,000	112,000
Allocated Fixed Costs	93,000	62,000	120,000
Net Income	$42,000	− $3,000	$45,000

Use the incremental approach to determine if Product B should be dropped.

Solution

By dropping Product B, the company will loose the sale revenue from the product line. The company will also obtain gains in the form of avoided costs. But it can avoid only the variable costs and direct fixed costs of product B and not the allocated fixed costs. Hence:

If Product B is Dropped
Gains:
Variable Costs Avoided	$169,000
Direct Fixed Costs Avoided	$86,000	$255,000
Less: Sales Revenue Lost		$314,000
Decrease in Net Income of the Company		$59,000

6 - Why are direct fixed costs typically differential costs?

What is Differential Cost?

Differential cost refers to the difference between the cost of two alternative decisions or a change in output levels. The cost occurs when a business faces several decisions to make, and a choice must be made by picking one decision and dropping the other. When business executives are faced with such situations, they must select the most viable option that increases revenues. They must determine the cost of both options and calculate the cost of picking one option over another in order to make a sound decision. In most cases, the main influencing factors when making such decisions are costs and profits for each option.

Effective business executives can predict how things would go depending on the direction the company takes. If it takes the right direction, then there is potential for growth and an increase in revenues. However, if the business takes the wrong direction, the company is likely to incur a loss, demotivate employees, or see a decline in revenues, depending on the circumstances involved. Businesses use differential cost to make critical decisions on long-term and short-term financial issues. Differential cost also gives managers tangible numbers that act as the basis for developing company strategies.

Example of Differential Cost

ABC Company is a telecom operator that primarily relies on newspaper ads and the company website for marketing. However, a recently hired marketing director suggests that the company should now focus on television ads and social media marketing to reach a broader client base.

The telecom operator currently spends $400 on newspaper ads and $100 on maintaining the company’s website every month. The marketing director estimates that it will spend approximately $1,000 on television ads every month. Also, the company will need to hire a millennial at $250 per week to oversee its social media marketing efforts. If the telecom operator adopts the new advertisement techniques, they will spend $2,000 per month as advertisement expenses. The differential cost, in this case, is $1,500 ($2,000 – $500).

ABC Company must decide between remaining with their current advertisement platforms or adopting the suggested advertisement platforms, which translate to additional costs. They must calculate the benefits and gains of choosing one option and leaving the other. If the business faces a tight budget and is getting a few clients via the old advertising platforms, the company may prefer to stay put in its current state. However, if the business goes ahead and implements the new option, it means it gains access to a wider market for its products and services by choosing to spend more money. Another advantage is that social media advertising will give the company an opportunity to interact with its customers directly to know their concerns and suggestions on the company’s current products.

Treatment of Differential Cost

Differential cost may be a fixed cost, variable cost, or a combination of both. Company executives use differential cost to choose between options to make viable decisions to positively impact the company. Therefore, no accounting entry is required for this cost because it is not an actual transaction. Also, there are no accounting standards that guide how differential costs are treated.

Opportunity Cost

Opportunity cost refers to potential benefits or incomes that is foregone by choosing one option over another. The cost does not require any payments of cash or its equivalent. The company executives must choose between options that are attractive, but the decision should be made after taking into account the opportunity cost of other alternative options. Choosing either of the options must be based on analytical calculations rather than instincts.

In the case of ABC Company, moving to television ads and social media marketing exposes the company to a broader customer base. If the company earned $10,000 using the current marketing platforms, moving to the more advanced advertising platforms might result in a 40% revenue increment to $14,000. The move places the opportunity cost of choosing to stick to the old advertising method at $4,000 ($14,000 – $10,000). The $4,000 is the income that ABC would forego for remaining with the old marketing techniques and failing to adopt the more sophisticated marketing models.

Sunk Costs

Sunk costs refer to costs that a business has already incurred but that cannot be changed by any decision of the executive. They may occur 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.

As an extreme hypothetical example, consider a company engaged in plastic bag manufacturing that may acquire a more advanced machine to double its current production of plastic bags. As soon as the company puts the machine into use, the government bans the manufacturing of plastic bags in the country and makes it a crime for any person to manufacture or sell plastic bags. The new regulation renders the machine and the produced plastic bags obsolete and the company cannot change the government’s decision.

7. Why are allocated fixed costs typically not differential costs?

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

8.A. What is an opportunity cost?

Opportunity cost refers to potential benefits or incomes that is foregone by choosing one option over another. The cost does not require any payments of cash or its equivalent. The company executives must choose between options that are attractive, but the decision should be made after taking into account the opportunity cost of other alternative options. Choosing either of the options must be based on analytical calculations rather than instincts.

In the case of ABC Company, moving to television ads and social media marketing exposes the company to a broader customer base. If the company earned $10,000 using the current marketing platforms, moving to the more advanced advertising platforms might result in a 40% revenue increment to $14,000. The move places the opportunity cost of choosing to stick to the old advertising method at $4,000 ($14,000 – $10,000). The $4,000 is the income that ABC would forego for remaining with the old marketing techniques and failing to adopt the more sophisticated marketing models.

8.B. Why is an opportunity cost a differential cost?

A differential in accounting compares the cost of two or more items or the outcome of one choice over another. The difference in cost between the choices is the differential cost. Opportunity cost, on the other hand, represents the benefits you might miss out on when choosing one alternative over another

9. How is differential analysis similar for customer decisions and product line decisions?

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.

Often managers need to decide if dropping a customer is profitable than keeping him. The manager can use differential analysis with variable cost associated with the customer, the fixed cost directly related to the customer along with any other allocated fixed cost that is not directly related to the specific customer.

For example for an online only bank, the variable costs would include customer support cost, interest / dividend payment to the customer etc and fixed cost would be information technology maintenance cost, employee cost etc. But notice, that these fixed costs are not specific to the customer, these costs would continue whether or not any particular customer is retained or dropped. When the customer makes the company make loss, then the manager would perform differential analysis to determine if it is profitable to drop the customer or to keep him so that the total profit does not drop.

Describe Differential analysis regarding product line offerings

Any company that wants to introduce a new product or wants to decide on – whether of not to continue with existing product from their offering can use differential analysis to determine the most profitable decision for the company.

For example, say a Yogurt company wants to determine if dropping one particular flavor of yogurt that basically makes loss, should remain in their product offering or should it be just dropped to increase overall profit.

Describe Differential analysis regarding Make-or-Buy decisions

Companies making products can determine using differential analysis whether or not manufacturing in house would be profitable or should they just buy that product from a supplier to make a bigger profit. Discuss the role qualitative information may have in differential analysis

Differential analysis usually does not focus on qualitative information while making decisions. For example, when I gave the example of a bank customer who is not profitable for the bank, and bank has to spend too much money on him with customer support. Eventually the customer would require less support and he would deposit larger sum of money and the bank would be able to make good profit out of him. Or in the example where I said, the café can decide to outsource the cookies, but considering qualitative information would make the café manager re-consider his decision – the quality of ingredients for the cookies might not meet the café standards, the supplier can deliver late. Firing the baker might have bad effect on existing employees etc.

So qualitative information which does not relate to exact profit figures but it might play a significant part in determining the decision from differential analysis.

For example say a cafe sells cookies, and to make those cookies the cafe needs the oven, ingredients, baker etc. Differential analysis can help us determine if simply buying those cookies from outside would help them save money or not, provided the cafe has some fixed costs such as rental of the place, leasing cost of the oven etc and some variable costs such as ingredients, the employees.

10. What two important assumptions must be considered when evaluating special order scenarios?

A special order is a unique, one-time order made by a customer that requires a variation in the manufacture of your regular products. Your accounting staff should analyze the proposal and determine whether to accept or reject the special order. This will be based on sales revenue, costs of production and the long-run implications of additional costs to accommodate special orders, as you may have to either leverage idle capacity or drop a process segment if you face resource constraints.

When there is idle capacity or when sales are low, you can accept special orders as long as the incremental revenue surpasses incremental costs. When production is running at full capacity, more calculations are required in decision making.

A special order will typically involve a large quantity of products or service at a specified price. Your accounting manager's feedback will hinge on how to maximize your profit. The proposal should be accepted only if the incremental revenue associated with the special order exceeds incremental costs and if present sales will be unaffected.

With fixed costs already accounted for in regular production, you will need to optimize the price point based on the variable costs to turn a profit. Soft benefits, like maintaining a business relationship, should be considered as well.

Idle Capacity

In order to complete the special order, your company must have the ability to perform the task. To avoid disrupting production, you need to have the capacity to fill the special order in terms of personnel and equipment on the production line. If you're operating at full capacity, you'll have to turn away regular customers to accommodate the special order. This can only be justified if the order produces a large enough profit to overcome the disruption.

Special Order Pricing

Since a special order is a one-time order, it represents a short-run pricing decision. Use the special order pricing technique to ensure profit – calculate the lowest price of the product or service at which to accept the special order. Even if the price is set below regular price, the sale may still generate a profit above variable costs. When there is idle capacity or when sales are low, you can accept special orders as long as the incremental revenue surpasses incremental costs.

Example of Accounting Decision Making

Suppose your company manufactures caps for sports brand names and currently produces and sells 100,000 units. Your monthly fixed cost is $300,000 and the variable cost per cap is $4, comprising $3 for the material and $1 for labor. Sports retailers purchase each cap for $10. Assume you receive a special order for 15,000 caps at $9 each.

Regardless of whether you take the special order, you will incur the fixed cost. The same variable costs of $4 per unit apply and the special order will cost $60,000 to produce and sell for $135,000. With idle capacity you'll make 115,000 units, generating a profit of $375,000 instead of the regular $300,000. At full capacity, you displace 15,000 regular units, realizing an opportunity cost of $90,000 and a profit of $285,000.