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