Mastery Problem: 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 not relevant

• relevant
• not relevant

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 sunk costs

• fixed costs
• opportunity costs
• sunk costs
• variable costs

. Revenue given up by not choosing an alternative is relevant. This is an example of an opportunity cost

• a fixed cost
• an opportunity cost
• a sunk cost
• a variable cost

. Factors that These factors are called qualitative factors. An example of a relevant qualitative factor is the effect on employee morale with a plant closing decision.cannot be expressed in numerical terms may or may not be relevant to the decision.

Indicate whether the costs that are described are Relevant costs and revenues are future costs and revenues that will change with a decision.relevant or Irrelevant costs and revenues will not change based on the decision.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		Relevant Relevant Irrelevant
The future depreciation on a new machine with the decision to replace an older fully depreciated machine (assume no tax benefit for depreciation)		Irrelevant Relevant Irrelevant
The revenue given up by not choosing an alternative		Relevant Relevant Irrelevant
The risk of substandard quality from an outside supplier with the decision to outsource		Relevant Relevant Irrelevant
Variable costs that are the same for all alternatives under consideration		Irrelevant Relevant Irrelevant

Feedback

Relevant costs and revenues are future costs and revenues that will change with a decision. Irrelevant costs and revenues will not change based on the decision.

Managers often have to choose between Mutually exclusive means that both choices cannot be made. If one alternative is chosen, the other alternative is given up.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 differential

• differential
• overhead
• regression
• statistical

analysis, or incremental analysis. The concept is to determine the Differential revenue less differential costs. Differential income indicates an increase to income and a differential loss indicates a decrease in income.differential income or loss from choosing one option over the other. If irrelevant costs are included in one option, the cost should

• should
• should not

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 17,000 monitors from an outside supplier for $214 per unit. One of the company's cost-accounting interns prepared the following schedule of Zee-Drive's cost to produce 17,000 monitors:

	Total cost of producing 17,000 monitors		Unit cost
Direct materials	$	1,972,000	$	116
Direct labor		1,275,000		75
Variable factory overhead		629,000		37
Fixed manufacturing overhead		476,000		28
Fixed non-manufacturing overhead		646,000		38
	$	4,998,000	$	294

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 $50,400, but non-manufacturing costs would remain the same if monitors are bought.

Fill in the differential analysis.

Make or Buy Decisions Differential Analysis Report
Purchase price of 17,000 monitors		$
Differential cost to make:
Direct materials	$
Direct labor
Overhead
Differential income (loss) from making monitors		$

Feedback

Enter only the differential relevant costs in the appropriate space and calculate differential income or loss. The challenge is in determining differential overhead.

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	$433,400
Current accumulated depreciation	317,400
Estimated annual variable manufacturing costs for machine	74,750
Estimated selling price of machine	169,600
Estimated remaining useful life (in years)	6
New Machine:
Purchase cost	$818,300
Estimated annual variable manufacturing costs for machine	51,350
Estimated residual value	0
Estimated useful life (in years)	6

Select the relevant or irrelevant information below:

Annual variable costs of old machine	Relevant Relevant Irrelevant
Selling price of old machine	Relevant Relevant Irrelevant
Matching lives	Relevant Relevant Irrelevant
Purchase price of new machine	Relevant Relevant Irrelevant
Accumulated depreciation of old machine	Irrelevant Relevant Irrelevant

Fill in the differential analysis.

Replace or Keep Decision Differential Analysis Report
Cost of replacing old machine:
Annual differential decrease in cost	$
x number of years
Total differential decrease in cost
Proceeds from sale of present machine		$
Cost of new machine
Net differential (increase)/decrease in cost, six year total		$

Feedback

Multiply the annual differential decrease in costs attributable to the new machine by six years to determine the total differential decrease in cost. Then add the proceeds from the sale of old machine. The cost of the new machine is the purchase cost. The difference is either an increase or decrease in costs. The machine should be replaced only if there is cost savings.