Decision Making using Differential Analysis

Decision making involves quantifying relevant revenues and costs with the goal of maximizing net cash flows. In many situations it is difficult to quantify all the important elements of a decision. Fixed costs are generally - Select your answer -relevantnot relevantCorrect 1 of Item 1 in the short-term because they are often unavoidable. Costs that have been incurred in the past and cannot be recouped are not relevant. These costs are called - Select your answer -fixed costsopportunity costssunk costsvariable costsCorrect 2 of Item 1 . Revenue given up by not choosing an alternative is relevant. This is an example of - Select your answer -a fixed costan opportunity costa sunk costa variable costCorrect 3 of Item 1 . Factors that cannot be expressed in numerical terms may or may not be relevant to the decision.

Indicate whether the costs that are described are relevant or irrelevant for decision-making purposes.

The cost to hire and train temporary labor to cover normal business processes so permanent employees can work on the project that is being considered		- Select your answer -RelevantIrrelevantCorrect 4 of Item 1
The future depreciation on a new machine with the decision to replace an older fully depreciated machine (assume no tax benefit for depreciation)		- Select your answer -RelevantIrrelevantCorrect 5 of Item 1
The revenue given up by not choosing an alternative		- Select your answer -RelevantIrrelevantCorrect 6 of Item 1
The risk of substandard quality from an outside supplier with the decision to outsource		- Select your answer -RelevantIrrelevantCorrect 7 of Item 1
Variable costs that are the same for all alternatives under consideration		- Select your answer -RelevantIrrelevantCorrect 8 of Item 1

Managers often have to choose between mutually exclusive alternatives. The first step is to identify the alternatives and the relevant revenues and costs of each option. The next step is to compare the alternatives. This is called - Select your answer -differentialoverheadregressionstatistical Correct 1 of Item 2 analysis, or incremental analysis. The concept is to determine the differential income or loss from choosing one option over the other. If irrelevant costs are included in one option, the cost - Select your answer -shouldshould notCorrect 2 of Item 2 also be included in the other options for comparison purposes.

Make or buy decisions, sell or process further decisions, lease or buy decisions, whether to accept an order at a discounted price, and when to replace equipment, are all examples of common decisions where differential analysis is used.

Many formats may be used. Click here for a template that includes all revenues and costs. Click here for a template with relevant costs only.

Make or Buy Decision:

Zee-Drive Ltd. is a computer manufacturer. One of the items they make is monitors. Zee-Drive has the opportunity to purchase 19,500 monitors from an outside supplier for $213 per unit. One of the company's cost-accounting interns prepared the following schedule of Zee-Drive's cost to produce 19,500 monitors:

	Total cost of producing 19,500 monitors		Unit cost
Direct materials	$	2,340,000	$	120
Direct labor		1,306,500		67
Variable factory overhead		741,000		38
Fixed manufacturing overhead		487,500		25
Fixed non-manufacturing overhead		760,500		39
	$	5,635,500	$	289

You are asked to look over the intern's estimate before the information is shared with members of management who will decide to continue to make the monitors or buy them. The company's controller believes that the estimate may be incorrect because it includes costs that are not relevant. If Zee-Drive buys the monitors, the direct labor force currently employed in producing the monitors will be terminated and there would be no termination costs incurred. There are no materials on hand and no commitments to suppliers to purchase materials, so all materials would need to be purchased to make the monitors. Variable overheads are avoidable if monitors are bought. Fixed manufacturing overhead costs would be reduced by $57,500, but non-manufacturing costs would remain the same if monitors are bought.

Fill in the differential analysis. If an amount box does not require an entry, leave it blank or enter "0".

	Cost of producing 19,500 monitors	Cost to purchase 19,500 monitors	Difference costs/(savings) of buying 19,500 monitors
Direct materials	$	$	$
Direct labor
Variable factory overhead
- Select your answer -Fixed manufacturing overheadFixed non-manufacturing overheadRedundancy costsCorrect 12 of Item 2
- Select your answer -Outside purchase costsFixed non-manufacturing overheadMonitors in finished goods inventoryCorrect 16 of Item 2
Total costs	$	$	$

Keep or Replace Machine:

Skiles Coporation is a manufacturer of classic rocking chairs. The company has been using a particular sanding and finishing machine for over 10 years and believes that it may be time to replace the machine. The company is trying to decide whether replacing the old machine is a wise economic decision. The company's controller pulled together the following information on the old machine and the new possible replacement machine.

Old Machine:
Original cost	$436,400
Current accumulated depreciation	336,900
Estimated annual variable manufacturing costs for machine	74,350
Estimated selling price of machine	199,300
Estimated remaining useful life (in years)	6
New Machine:
Purchase cost	$794,500
Estimated annual variable manufacturing costs for machine	46,050
Estimated residual value	0
Estimated useful life (in years)	6

Select the relevant or irrelevant information below:

Annual variable costs of old machine	- Select your answer -RelevantIrrelevantCorrect 1 of Item 3
Selling price of old machine	- Select your answer -RelevantIrrelevantCorrect 2 of Item 3
Matching lives	- Select your answer -RelevantIrrelevantCorrect 3 of Item 3
Purchase price of new machine	- Select your answer -RelevantIrrelevantCorrect 4 of Item 3
Accumulated depreciation of old machine	- Select your answer -RelevantIrrelevantCorrect 5 of Item 3

Fill in the differential analysis. If an amount box does not require an entry, leave it blank or enter "0".

	Replace old machine	Continue with old machine	Difference (Cost)/Savings with replacing machine
Revenue:
Proceeds from sale of old machine	$	$	$
Costs:
Cost of new machine
Variable costs (6 years worth)
Total costs	$	$	$
Income (loss)	$	$	$