Ch. 6 Differential Analysis: The Key to Decision Making
Are variable costs always relevant costs? Explain
No, variable costs are only relevant if they differ between alternatives
What is a Special Order Decision?
One-time order that is not considered part of company's normal ongoing business
What is the Differential Cost Approach?
Cost approach that focuses solely on the relevant costs and benefits
What is a Value Chain?
a network of value-creating activities from development, to production, to after-sales service
What are the 6 Key Concepts of Decision Making?
1. DEFINE Alternatives 2. Identify Criteria for Choosing which Alternative 3. Differential Analysis 4. Sunk costs are ALWAYS irrelevant when choosing among alternatives 5. Future costs and benefits that DO NOT differ between alternatives are IRRELEVANT to decision-making process 6. Consider Opportunity Costs
What is the Total Cost Approach?
Cost approach that includes all of the costs and benefits- relevant or not
What is a Sunk Cost?
Cost that has already been incurred and cannot be changed by any decision made now or in the future
What are Joint Costs?
Costs incurred up to the split-off point in process that produces joint products - Always sunk, Ignore these costs
What is a Bottleneck?
Machine or some other part of a process that limits total output of entire system
"All future costs are relevant in decision making" do you agree? Why?
No, future costs are only relevant if they differ between cost alternatives.
"Sunk costs are easy to spot- they're fixed costs associated with a decision" Do you agree with this? Explain
No, it's a cost that has already been incurred and cannot be changed
"Variable costs and differential costs mean the same thing" do you agree? Explain
No. A variable cost is a cost that varies in total amount in direct proportion to changes in the level of activity. A differential cost is the difference in cost between two alternatives. If the level of activity is the same for the two alternatives, a variable cost will not be affected and it will be irrelevant.
3 Step process to prepare analysis showing whether product line or business segment should be added or dropped
1. Calculate Contribution Margin that would disappear if the segment is dropped - put number in parentheses to denote it as a negative number 2. Calculate fixed costs that would be avoided if segment is dropped - do NOT put in parentheses 3. Add amounts from Step 1 and Step 2 - if NEGATIVE —-> DO NOT drop segment - if POSITIVE ——-> DO Drop segment
3 Step Process to prepare a Make or Buy Analysis
1. Calculate Total Amount that would be paid to supplier if buy option is chosen 2. Calculate total differential manufacturing - These are variable manufacturing costs and traceable fixed manufacturing costs that will be: - Incurred if company chooses to make - Avoided if company chooses to buy 3. Calculate difference between amounts of Step 1 and Step 2 - if Step 1 > Step 2: Choose MAKE option - If Step 1 < Step 2: Choose BUY option
What guidelines should be used in determining whether a joint product should be sold at the split off point or processed further?
1. Calculate sales value if process further - sales value at split off point 2. Determine cost of further processing beyond split off point 3. Subtract step 1 - step 2 - if positive —> process further - if negative —> sell at split off point
What is a Relevant Cost?
A cost that should be considered when making decisions Ex: differential costs, incremental costs, opportunity cost
What is a Volume Trade-Off Decision?
A decision made when company doesn't have enough capacity to produce all of the products and sales volumes demanded by their customers
What is a Constraint?
Anything preventing you from getting more of what you want - limitation under which a company must operate that restricts company's ability to satisfy demand - Ex: Limited available machine time, limited raw materials
What is the 6th Key Concept of Decision Making?
Consider Opportunity Costs
What is the Sell or Process Further Decision?
Decision as to whether a joint product should be sold at the split off point or sold after further processing
What is a Sourcing Decision?
Decision concerning whether a product or service should be produced or provided internally or purchased from an outside vendor
What is the 1st Key Concept of Decision Making?
Defining Alternatives- every decision involves choosing from among at least 2 alternatives 1. Make or buy component 2. Keep or Drop a product
What is the 3rd Key Concept of Decision Making?
Differential Analysis- focusing on future costs and benefits that differ between alternatives 1. Differential Costs: Future cost that differs between any two alternatives - Always Relevant - Ex: Incremental and Avoidable costs 2. Differential Revenue: Future revenue that differs between any two alternatives
What is the 5th Key Concept of Decision Making?
Future costs and benefits that DO NOT differ between alternatives are IRRELEVANT to the decision-making process - Ignore them
What is the 2nd Key Concept of Decision Making?
Identify Criteria for Choosing Which Alternative 1. Relevant Costs: Costs that should be considered when making decisions 2. Relevant Benefits: Benefits that should be considered when making decisions 3. IGNORE IRRELEVANT costs and benefits to save time
What are 2 types of Differential Costs?
Incremental Cost: increase in cost between two alternatives Avoidable Cost: cost that can be eliminated by choosing one alternative over another in a decision - Same as differential and relevant cost
Define the following Terms: Incremental Cost, Opportunity Cost, and Sunk Cost
Incremental cost- increase in cost between alternatives Opportunity cost- potential benefit given up when one alternative chosen over another Sunk cost- cost already incurred, should be ignored, no changing it
Define joint products, joint costs, and split-off point
Joint products- two or more products produced from a common input Joint costs- costs incurred up to split-off point in process that produces joint products Split-off point- point in manufacturing process where some or all of joint products can be recognized as individual products
What is the Split-Off Point?
Point in manufacturing process where some or all of the joint products can be recognized as individual products
What are Opportunity Costs?
Potential benefit that is given up when one alternative is selected over another - not usually found in accounting records
Why should you Isolate Relevant Costs?
Rarely, will enough info be provided to prepare detailed income statement for both alternatives Combining irrelevant costs with relevant costs may cause confusion and distract attention from critical info
What is the 4th Key Concept of Decision Making?
Sunk costs are always irrelevant when choosing among alternatives
Using the Differential Cost Approach, a positive number indicates ___
The difference between the alternatives favors the suggested option
Using the Differential Cost Approach, a negative number indicates ____
The difference favors the current situation
Prentice Company is considering dropping one of its product lines. What costs of the product line would be relevant to this decision? What costs would be irrelevant?
The relevant costs for Prentice Company are the ones that differ between keeping or dropping the product line. These are relevant to the decision because they are avoidable. The irrelevant costs are the ones that will be incurred regardless of what decision they make. They do NOT differ between alternatives; therefore, they are NOT relevant.
Using the Differential Cost Approach, a zero indicates ___
The total amount is exactly the same for both alternatives
What are Joint Products?
Two or more products that are produced from a single raw material input Ex: in petroleum refining industry, can extract gasoline, jet fuel, lubricants etc
What does Vertically Integrated Mean?
When a company is involved in more than one of the activities in the entire value chain from development through production, distribution, sales, and after-sales service