Module 14. Differential Analysis
Lesson 47 Quizzes question
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opportunity costs.
the most desirable alternative given up as the result of a decision
1 / 1 In the context of considering whether to drop a product line, what is a common cost?
A cost that is not directly related to any specific product line Correct! Common costs are costs that are common across the company and are not directly related to any specific unit or product line.
What is a critical resource factor?
A resource that limits operating capacity by its availability Correct! A critical resource factor is the resource that limits operating capacity by its availability.
Sunk costs
Already incurred or a future costs that CANNOT be changed/avoided, regardless of what manager does.
Which of the following statements is correct with regards to performing this type of differential cost analysis between these two alternatives?
Any costs that can be avoided by purchasing are differential costs. Correct! Unavoidable fixed manufacturing costs are sunk costs and are irrelevant to the differential cost analysis in this situation. All other costs, such as the direct materials, the direct labor, and the variable manufacturing overhead costs are relevant and part of the differential cost analysis in this situation.
When you are deciding whether to expand your business, what is the amount that you must pay to hire a new assistant manager called?
Differential cost Correct! You must carefully consider the new costs that will be incurred, such as the cost of hiring a new assistant manager.
Remember this:
Differential costs are the future costs that change as a result of a decision. Only differential costs and revenues are relevant to decisions. Some future costs may not be differential because they do not change as a result of a decision. Both variable and fixed costs may be differential. Sunk costs are never relevant because they are either past costs or future costs that cannot be changed. Once the quantitative analysis has been completed, qualitative factors must be considered.
You own the scenic tour company that takes people on sightseeing tours. You are fully booked but have received a special request to take five very important people on a tour of some local attractions. You realize that to accept the tour, you will need the following: A rented four-wheel-drive jeep$1,000 Meals for the five guests$100 Gasoline and other expenses of the tour$200 Overtime pay for one employee costing$500 The organization requesting the tour is willing to pay you $500 each for the five guests that will participate. How much will your income increase or decrease if you choose to accept the requested tour?
Income will increase by $700. Correct! The total out of pocket costs are $1,800 ($1,000 + $100 + $200 +$500). The total income is $2,500 (five people at $500 each). The incremental profit is $700 ($2,500 − $1,800). However, there may be significant qualitative factors to consider.
Bitter Root oil company extracts oil from underground wells. The total cost of extracting a fifty-five gallon barrel of oil is $110. It can sell the fifty-five gallon barrel of oil as is for $165 or process it further at an additional cost of $0.50 per gallon and sell it for $3.75 per gallon. However, in further processing the oil, 5 of the 55 gallons are lost. What is Bitter Root's profit or loss if it processes the oil farther instead of selling it upon extraction?
Loss of $5 per barrel If Bitter Root performs the extra processing, it will lose a total of $5 per barrel. Current cost to extract: $2 per gallon or $110 per barrel (55 × $2). Revenue if don't process further is $3 per gallon or $165 per barrel (55 × $3). Increase in cost if process further is $0.50 × 55 barrels or $27.50 per barrel. Increase in revenue is $0.75 × 50 gallons (5 gallons are lost) or $37.50. Lost revenue from 5 barrels that are lost is $3 × 5 gallons or $15. Total cost of processing further is lost revenue of $15 plus cost of processing further or $27.50 or a total of $42.50 per barrel. Extra revenue is $37.50, so there is a net loss of $5 per barrel by processing further.
Outsourcing is associated with which application of differential analysis?
Making or buying a product or service Correct! The term "outsourcing" means paying another company to provide a product or service that you could make yourself.
When you decide to invest in a stock mutual fund instead of a money market fund, what are the costs that you could have earned in the money market fund called?
Opportunity costs Correct! If you invest in the stock mutual fund, you are giving up the opportunity to earn the return on the money market fund.
cost examples
Paper: The cost of the paper for the printing job is differential because it is a future expenditure that must be made as a result of the decision to accept the order. In a sense, therefore, it is a cost that changes as a result of the decision. If you do not accept the order, you do not need to purchase the paper. Note also that paper is a variable cost—its total cost increases proportionately to the size of the order. Printing labor: Accepting the order will require a future expenditure for additional labor to operate the press. This again obviously represents a change from the existing situation—without the order, you would not incur the cost of labor. Also, because this rush order will have to be printed during overtime hours, the appropriate labor rate is time and a half. (Given a normal hourly rate of $16, the labor rate for this job would be $24.) It is easy to overlook this and assume that the normal labor cost per hour ($16) applies. The differential cost of $24 per hour that will be incurred as a result of the decision, however, is the appropriate cost to use. Like paper, printing labor is a variable cost that increases proportionately to the size of the order. Printing plates: New printing plates must be prepared for this order, so it is a future expenditure that changes as a result of the decision to accept the order. The important point here is that printing plates are a fixed cost (you can print as many copies as you want from the same set of plates), but the cost is still differential because it is an additional expenditure for this order. A common but incorrect assumption is that only variable costs are relevant and that fixed costs do not have to be taken into account. This is not the case. All future costs that change as a result of accepting the order, whether fixed or variable, are differential. Printing press depreciation: This is not a differential cost because it is not a future cost (depreciation is an allocation of a past cost), and it does not change as a result of the decision to accept the order. Costs such as depreciation, which are past costs and do not change, are sunk costs. No future decision can change sunk costs; they are never relevant to a decision. Manager's salary: Although the manager's salary is a future cost (you will be paying for future services), it will be paid whether or not the order is accepted. Consequently, despite being a future cost, the manager's salary is a sunk cost because it must be paid regardless of whether the printing job is accepted.
What is a sunk cost?
Past costs that cannot be changed Correct! A sunk cost is a cost that has already been incurred or a future cost that cannot be avoided, regardless of what a manager decides to do.
Lesson summary
Relevant costs are those costs that will differ depending on a decision. Focusing on just the relevant costs helps keep the analysis from being cluttered by things that are not impacted by the decision. In making a decision, sunk costs are very difficult to ignore because you have already paid good money for this cost. However, the nature of a sunk cost is that no decision you can make now can change the amount of a sunk cost. If a decision cannot change the cost, then the cost should be ignored in decision-making. Opportunity costs are easy to overlook. An opportunity cost is a benefit lost from choosing one alternative because now the benefits from other potential alternatives are not available. For example, choosing to place your money in one investment means that you have lost the benefits associated with putting your money in a different investment. In some decisions, the opportunity costs are by far the most important factors to consider.
When you are deciding whether to accept someone's offer to buy your car, what is the amount that you paid to buy your car called?
Sunk cost Correct! The only thing that is relevant is what the car is worth now. The amount that was paid for the car in the past is an irrelevant sunk cost.
When should a company process a joint product further?
When incremental revenues are greater than incremental costs In choosing the best time to stop processing a product, management compares the additional costs that would be incurred from further processing with the additional revenues. If the incremental revenues are greater than the incremental costs, net income is increased and additional processing is worthwhile.
Under what circumstances is it appropriate to accept a special order at a price below the normal price?
When there is excess capacity Correct! A special order is an order that may be priced below the normal price to utilize excess capacity.
Differential costs
avoidable incremental costs. Relevant for decision making and can choose alternative over another.
Lesson 44 Question 2-5
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Endothon manufactures lamps. Kretsmart, a large retail merchandiser, wants to buy 200,000 lamps from Endothon for $11 each. Endothon normally sells 420,000 lamps a year at $16 each. Its production capacity is a total of 550,000 units a year. The production cost information for the lamps is found in the table below: variable production costs: 6$ per unit fixed manufacturing overhead: 7$ per unit Total production costs: 13$ per unit Kretsmart has indicated that the company is not interested in signing a contract for less than 200,000 lamps. Based on this information, what is the change in Endothon's net income because of the contract?
differential contribution margin 200,00 x (11-6) = 1000000 opportunity cost lost contribution margin 70,000 x (16 - 6) = 700000 differential profit = 300,000
Segment margin
if negative and discontinued = positive net income if positive and discontinued = negative net income(money lost) Study questions quiz lesson 45 2-5
Special order
order priced below normal price - to utilize excess capacity
The cost information for the manufacture of one computer is in the table below: Direct materials $48 Direct labor 64 Variable manufacturing overhead 48 Fixed manufacturing overhead 32 Total cost per unit$192 Karmlon has received a special order for 500 computers at a price of $175 per unit. Calculate the difference in Karmlon's net income with this special order.
remember you don't include fixed costs/sunk costs 48+64+48 = 160 total differential costs 500computers x 175 = 87500 500computers x 160 = 80000 7500 therefore the decreased price produces bigger profit.
Study lessson 46 question quiz 2-5
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The differential costs are
variable costs direct fixed costs opportunity cost of alternative uses of the resource