Differential Analysis: Keep-or-Drop Decisions

Managers must often decide between two or more alternatives. Differential analysis is used in decision making. When using differential analysis, it is important to only include those amounts that are different between the alternatives. Differential cost is subtracted from differential revenue to determine differential income/loss.

Differential analysis requires that relevant costs must be identified. When determining which costs are relevant, which of the following statements is true?

SelectAll fixed costs are irrelevant.All mixed costs are relevant.All variable costs are relevant.Relevancy must be determined on a case-by-case basis.Correct 1 of Item 1

For example, a manufacturing company may have a segment or product that is operating at a loss. The decision to keep the segment/product or discontinue it is called a keep-or-drop decision and uses differential analysis to assist in the decision-making process.

Differential analysis is only one step in deciding to keep or drop the segment or product. Management must also take into consideration nonquantitative data. If the company drops a product, will it affect the sales of other products? If employees are laid off or terminated, will it affect employee morale? These nonquantitative issues will influence the success or failure of a keep-or-drop decision.

APPLY THE CONCEPTS: Calculate remaining cost in a keep-or-drop decision

Scoot Corporation makes three products: snowboards, skateboards, and skis. The contribution margin income statement for each department is provided:

	Snowboards	Skateboards	Skis
Sales	$155,000	$200,000	$165,000
Less: variable expenses	62,000	40,000	57,750
Contribution margin	$93,000	$160,000	$107,250
Less: fixed expenses:
Salaries	$54,250	$70,000	$66,000
Depreciation	10,000	30,000	33,000
Advertising	2,500	10,000	49,500
Net income (loss)	$26,250	$50,000	$-41,250

The net income for skis has been negative for several periods despite management's efforts to increase sales and decrease expenses. Therefore, Scoot Corporation is considering discontinuing production of skis. If the ski line is dropped, all variable costs currently associated with that department will be eliminated, as will all advertising costs, but only 70% of the salaries currently associated with that department will be eliminated. If the ski line is dropped, what amount of salaries will remain? Select$0$46,200$19,800$66,000Correct 1 of Item 2

APPLY THE CONCEPTS: Calculate differential income in a keep-or-drop decision

Complete the table to compare the effects of dropping the ski line of products. Enter all amounts as positive numbers except for a net loss. If an amount is zero, enter "0". The cost data for the each department is shown below.

		Snowboards	Skateboards	Skis
Sales		$155,000	$200,000	$165,000
Less: variable expenses		62,000	40,000	57,750
	Contribution margin	$93,000	$160,000	$107,250
Less: fixed expenses:
	Salaries	$54,250	$70,000	$66,000
	Depreciation	10,000	30,000	33,000
	Advertising	2,500	10,000	49,500
Net income (loss)		$26,250	$50,000	$-41,250

	Alternatives				Differential Effect
	Keep		Drop		Increase/Decrease
Sales	$				$
Less: variable expenses
Contribution margin	$				$
Less: fixed expenses:
Salaries	$		$		$
Depreciation
Advertising
Net income (loss)	$		$		$