Chapter 10 Differential Analysis: The Key to Decision Making
analysis of sell or process further ->incremental rev from further processing
1. Finial sales value after fruther processing 2. less sales value at the split off point =incremental revenue from further processing
examples of broad acitives include
1. R&D 2. prod design 3, manufacturing 4. marketing 5. distribution 6. customer services these collectively represent the value chain
steps to decide what product of a constrained resorce should be emphasized
1. calculate the CM of each product 2. calculate the CM per unit of constraint
when stoppung production avoidable costs may include
1. direct materials 2. direct labor 3. incemential overhead
general process of a make or buy decision
1. list all costs 2. classify all costs -avoidable -irrelevant -sunk -future costs that do not differ -opportunity 3. calculate relevant costs associated with make or buy 4. decide make or buy 5. determine maximum outsourcing price
Applications of Differential Analysis include
Adding/dropping segments Make or buy decisions special orders constrained resources managing constraints joint prouction sell or process further
First Key Concept to Decision Making
Every decision involves choosing from among at least two alternatives. therefore, the first step in decision making is to define the alternatives beng considered
analysis of sell or process further ->profit
Finial sales value after fruther processing less sales value at the split off point =incremental revenue from further processing less cost of furhter processing =Profit (loss) from further processing
Sixth Key Concept to Decision Making
Opportunity costs also need to be considered when making decisions. An opportunity cost is the potential benefit that is given up when one alternative is selected over another
Fourth Key Concept to Decision Making
Sunk costs are always irrelevant when choosing among alternatives. A sunk cost is a cost that has already been incurredd and cannot be changed regardless of what a manager decides to do
Third Key Concept to Decision Making
They key to effective decision making is differential analysis - focusing on the future costs and benefits that differ between the alternatives. A future cost that different between any two alternatives is known as a differential cost (often called avoidable costs). future revenue that differs between any two alternatives is known as differential revenue
Relevant benefit (what concept?)
a benefit that different between alternatives, also called a differential benefit or incremental benefit 2
Relevant cost (what concept?)
a cost that differs between alternatives is also called an avoidable cost, differnetial cost, or incremental cost. Relevant or avoidable costs are costs that can be eliminted in whole or in part by choosing one alternative over another 2
Future costs (what concept?)
a cost that does not avoidable regardless of the alternative action
Sunk cost (what concept?)
a cost that has already been incurred and cannot be avoided regardless of what a manger decides to do 4
constraint
a scarece resource that restricts production capacity to a certain level
special order
a special order is a one time order that is not considered part of the company's nromal ongoing buisness the question is shouldw e accept a special order at a lwoer than normal price
bottleneck
a station, step, or port of a process that delays the entire systems output all production efforts should go towards increasing capacity at teh bottle neck
special order decsion rule
accept the order if incremental enue exceeds incremental costs
Adding/dropping sement decisions are based on
adding or dropping a segment will have on net operting income
managing constraints fixed costs
are not considered because they usually unaffected by the decision
Joint Product Costs connundrum
businesses are often faced with the decision to sell partially completed products at the split off point or to process them the completion
Allocated fixed costs
can make a segment look less profitable that it actually is becuase allocated ixed costs are incurred by the business regardless of whether the segment is dropped (i.e they are common fixed costs) be sure to remove allocated when making a drop decision
managing constraints
capacity of an entire system is limited by a single or small number of components or resources deal with bottlenecks and constraints
contrabution margin approach to adding/dropping a segment
comparing the contrabution margin that would be lost if the costs that would be avoided if the line was to be dropping (using relevant information)
managing constrains decision rule
coose products with the largest contribution margin per unit of constrained resource (not necessarily products with the highest unit contribution margins)
opportunity cost (what concept?)
cost forgone for making one decision over another 6
allocated fixed costs include
depreciation (sunk) and general admin overhead (allocated fix)
allocated fixed costsa re an example of
futre costs that does not differ between alterantives 5
Fifth Key Concept to Decision Making
future costs and benefits that do not differ between alternatives are irrelevant to the decision making process
Relevant Information (what concept?)
includes relevant benefits and costs 2
if a product under a constraint has a high unit CM then
it is not nessicarly the highest proirty to keep it going
Reasons to keep a segment that shows a loss include
its revenues are covering some of the allocated fixed costs of the firm. and thus making the line seem not profitable, however if some of the costs making it appear unprofitable are unavoidable then assess more carefuly
make of buy decision
managers must decide whether to implement activities internally or buy from an external supplier
why isolate relevant costs
mingling irrelevant costs with relevant costs may cause confusion and distract attention from the critical information therefor it is best to ignore irrelevant data and base the decision entirely on relevant data
Future costs and sunk costs are
not relevant to decision making
Second Key Concept to Decision Making
once you have defined the alternatives, you need to identify the critria for choosing among them. the key to choosing between relevant and irrelevant costs and benefits. irrelevant costs are irrelevant benefits should be ifnored when making decisions
split off point
point in production where joint products become separate products
Joint Product Cost decision rule
process further only if incremental revenues > incremental processing costs after the split off point
how to deal with constraints
relaxing or elevating the constraint is an event or action that increases either the amount of a constrained resources or increases the capacity of a bottle neck so as to increase production
Joint costs are
shared costs of joint products that are incurred up unitl the spilt off point
make or buy opportunity cost
should be added to the cost incurred of making when comparing make or buy
if we are making the special order decision and running at cpacity
the min acceptable order price is still the marginal cost of those sales, but in this scenario the firm has to include the opportunity cost of the forgone normal sales the opportunity cost of the foregone normal sales is the lost contribution margin on those sales
CM per unit of constrainet
unit contribution margin / constraint
virtical integration
when a comany is involved with moe than just one part of the value chain