Differential Analysis: The Key to Decision Making | Managerial Accounting | CMA Exam | CPA Exam BEC |

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These lectures cover adding or dropping a product line, making or buying a component, accepting or rejecting a special order, using a constrained resource, and further processing joint products.

 

Relevant and Irrelevant Cost

Add or Drop a Segment or Product Line

Make or Buy Component

Accepting or Rejecting a Special Oder

Utilization of a Constrained Resources

Further Processing Joint Products

Everything in this chapter consists of applications of one simple but powerful idea—only those costs and benefits that differ between alternatives are relevant in a decision. All other costs and benefits are irrelevant and should be ignored. In particular, sunk costs are irrelevant as are future costs that do not differ between alternatives.

This simple idea was applied in a variety of situations including decisions that involve adding or dropping a product line, making or buying a component, accepting or rejecting a special order, using a constrained resource, and further processing joint products. This list includes only a small sample of the possible applications of the differential cost concept. Indeed, any decision involving costs hinges on the proper identification and analysis of the differential costs. We will continue to focus on the concept of differential costs in the following chapter where long-term investment decisions are considered.

Relevant costs for decision-making are defined as future costs that differ between and among decision alternatives. Relevant costs can also be defined as the sum of out-of- pocket costs plus opportunity costs. Alternatively, relevant costs are called “avoidable costs,” that is, costs that can be avoided by choosing one decision alternative over another. The principle of relevant cost analysis can be applied in a number of specific decisions involving manufacturing, service, and not-for-profit organizations. Relevant cost analysis was illustrated in this chapter within the context of the following decisions: whether to accept or reject a special sales order; sourcing decisions (i.e., make-vs.-buy decisions); lease-vs.-purchase decisions; whether to sell or further process a product; and, whether to keep or drop certain product.

When two or more products or services are involved, another type of decision must be made: to determine the correct product (or service) mix. With one production constraint, the answer is to produce and sell as much as possible of the product that has the highest contribution margin per unit of the scarce (or constrained) resource, such as machine time. With two or more con- strained activities, the analysis uses graphical and quantitative methods  to determine the optimum short-term product (or service) mix.

Strategic analysis complements relevant cost analysis by having the decision maker consider the qualitative and strategic issues involved in the situation.

A number of key behavioral, implementation, and legal issues must be considered in using relevant cost analysis. Too strong a focus on relevant costs can cause the manager to overlook important opportunity costs and strategic considerations. Other issues include the tendency to replace variable costs with fixed costs when relevant cost analysis is used in performance evaluation and the pervasive tendency to view fixed costs as somehow controllable and relevant when in fact they are sunk costs.