Differential Analysis: Chapter 12

Decision making: 2 step process

1. Eliminate costs and benefits that do not differ between alternatives 2. Use the remaining costs and benefits that differ between alternatives in making the decision. The costs that remain are the differential, or avoidable costs.

Vertical integration advantages

1. Ensures a smoother flow of parts and materials for production than a nonintegrated company 2. Some companies feel that they can control quality better by producing their own parts and materials 3. Integrated campus realize profits from the parts and materials that they choose to make instead of buy

Why differential approach is desirable:

1. Only rarely will enough information be available to prepare detailed income statements for both alternatives 2. Mingling irrelevant costs with relevant costs may cause confusion and distract attention away from the information that is really critical

Vertical integration disadvantages

A company may fail to take advantage of supplies who can create an economies of scale advantage by pooling demand from numerous companies. A company must be careful to retain control over activities that are essential to maintaining its competitive position.

Make/buy decision

A decision to carry out one of the activities in the value chain internally, rather than to buy externally from a supplier, is called a make or buy decision.

Adding/dropping segments

A decision to drop a new segment is going to hinge primarily on the impact the decision will have on net operating income.

Special order

A one-time order that is not considered part of the company's ongoing business. When analyzing a special order, only the incremental costs and benefits are relevant.

Activity-based costing and relevant costs

ABC can be used to help identify potentially relevant costs for decision-making purposes - however managers should exercise caution against reading more into this "traceability" than already exists

Allocated fixed costs

Allocated fixed costs can distort the keep/drop decision - answer lies in the way common fixed costs are allocated to products *Including unavoidable common fixed costs makes the product line appear to be unprofitable

Joint costs

Are incurred up to the split-off point

Relevant benefit

Benefit that differs between alternatives

Adding/dropping segments DECISION RULE

Compare contribution margins and if profits increase, segment should be dropped: fixed cost saving exceeded the lost contribution margin

Avoidable cost

Cost that can be eliminated, in while or in part, by choosing one alternative over another. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs. Costs that are never relevant in any decision: 1. Sunk costs 2. Future cost that does not differ between the alternatives

Relevant cost

Cost that differs between alternatives

Value of a constrained resource

Increasing the capacity of a contained resource should lead to increased production and sales

Sell or process further

Joint costs are irrelevant in decisions regarding what to do which a product from the split-off point forward. Therefore, these costs should not be allocated to end products for deacon making purposes With respect to sell or process further decisions, it is profitable to continue processing a joint product after the split-off point so long as the incremental revenue from such processing exceeds the incremental processing costs incurred after the split-off point.

Pitfalls of allocation

Joint costs are traditionally allocated among different products at the split-off point. A typical approach is to allocate joint costs according to the relative sales value of the end products. Although allocation is needed for some purposes scubas balance sheet inventory valuation, allocations of this kind are very dangerous for decision making

Managing constraints: Theory of constraints

Often possible for a manager to increase the capacity of a bottleneck (called relaxing or elevating the constraint). This can be done by: 1. Working overtime on the bottleneck 2. Subcontracting some of the processing that would be done at the bottleneck 3. Investing in addition machines at the bottleneck 4. Shifting working from non-bottleneck processes to the bottleneck 5. Focusing business process improvement efforts on the bottleneck 6. Reducing defective units processed through the bottleneck

Split off point

The point in the manufacturing process at which the joint products can be recognized as separate products

Constraint

When a limited resource of some type restricts the company's ability to satisfy demand - the machine or process that is limited overall output is called the bottleneck

Joint products

When two or more products are produced from a common input. Example: in the petroleum refining industry, a large number of products are extracted from crude oil