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 generallynot 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 calledsunk costs. Revenue given up by not choosing an alternative is relevant. This is an example ofan opportunity cost. Factors thatcannot be expressed in numerical termsmay or may not be relevant to the decision.

Indicate whether the costs that are described arerelevantorirrelevantfor 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 consideredRelevant

The future depreciation on a new machine with the decision to replace an older fully depreciated machine (assume no tax benefit for depreciation)Irrelevant

The revenue given up by not choosing an alternativeRelevant

The risk of substandard quality from an outside supplier with the decision to outsourceRelevant

Variable costs that are the same for all alternatives under considerationIrrelevant

Managers often have to choose betweenmutually exclusivealternatives. 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 calleddifferential

analysis, or incremental analysis. The concept is to determine thedifferential income or lossfrom choosing one option over the other. If irrelevant costs are included in one option, the costshouldalso 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. Clickherefor a template that includes all revenues and costs. Clickherefor 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 $197 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 $1,955,000 $115

Direct labor 1,207,000 71

Variable factory overhead 476,000 28

Fixed manufacturing overhead 459,000 27

Fixed non-manufacturing overhead 680,000 40

__________________________________________________

$4,777,000 $281

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 $53,300, 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$ ______

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 $427,800

Current accumulated depreciation 330,500

Estimated annual variable manufacturing costs for machine 74,000

Estimated selling price of machine188,500Estimated remaining useful life (in years)6

New Machine:

Purchase cost $817,500

Estimated annual variable manufacturing costs for machine 53,850

Estimated residual value 0

Estimated useful life (in years) 6

Select the relevant or irrelevant information below:

Annual variable costs of old machineRelevant

Selling price of old machineRelevant

Matching livesRelevant

Purchase price of new machine Relevant

Accumulated depreciation of old machineIrrelevant

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$______