Managerial Accounting:
An Introduction To Concepts, Methods, And Uses
Chapter 8
Differential Cost Analysis
for Production Decisions
Maher, Stickney and Weil
Learning Objectives
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

(Slide 1 of 2)
Explain why businesses apply differential
analysis to product choice decisions.
Explain the theory of constraints.
Identify the factors underlying make-or-buy
decisions.
Explain how to identify the costs of producing
joint products and the relevant costs for
decisions to sell or process further.
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Learning Objectives
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(Slide 2 of 2)
Explain the use of differential analysis to
determine when to add or drop parts of
operations.
Identify the factors of inventory management
decisions.
Explain how linear programming optimizes
the use of scarce resources.
Identify the use of the economic order
quantity model.
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Product Choice Decisions
(Slide 1 of 2)

Due to capacity limitations, firms must often
choose which goods to make and services to
provide

When the firm has a scarce resource used in
production (e.g., machine time, skilled labor)

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Firm should produce product that gives the largest
contribution margin per unit of constrained resource
If more than one scarce resource is involved,
choice is more difficult

May use linear programming to determine best product
mix
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Product Choice Decisions
(Slide 2 of 2)

Incorrect use of accounting information
 In making short-run product choice
decisions, one should not rely on product
cost information that includes cost
allocations
 Full-absorption product costing allocates
fixed manufacturing costs to units
produced

May result in incorrect decisions
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Theory of Constraints

(Slide 1 of 3)
Focuses on increasing the excess of
differential revenue over differential
costs when firms face bottlenecks
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Bottleneck-an operation in which the work
performed equals or exceeds the available
capacity
Results in inventory waiting until the
bottleneck is free
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Theory of Constraints


(Slide 2 of 3)
Encourages managers to find ways to
increase profits by relaxing constraints and
increasing throughput
Focuses on the following factors:
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Throughput contribution - Sales dollars minus
variable costs
Investments - Assets required for production and
sales
Other operating costs - Other than short-run
variable costs
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Theory of Constraints


(Slide 3 of 3)
Objective is to maximize throughput
contribution while minimizing investments
and operating costs
Key steps involved:
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Recognize that bottlenecks determine throughput
contribution for the plant as a whole
Find the bottleneck resource
Subordinate all nonbottleneck resources to the
bottleneck resource
Increase bottleneck efficiency and capacity
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Make-or-Buy Decisions

Involve the decision of whether to meet
needs internally or to acquire goods and
services from external sources (often
called outsourcing)

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Decision depends on cost factors as well as
nonquantitative factors
Differential cost analysis is useful in
making these decisions
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Example-Make or Buy Decision
(Slide 1 of 2)

Ben & Jerry Cookie Co. can buy part of its
product or produce it internally. Relevant info
is as follows:
Unit Selling Price
Sales Volume
Unit Variable Costs
Purchased Ingredients
Total Fixed Costs
Buy
$ 30
800/mth.
$ 11
$ 12
$3,840
Make
$ 30
800/mth.
$ 22
$
0
$4,800
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Example-Make or Buy Decision
(Slide 2 of 2)
__Buy
Make Difference
$24,000 $24,000
-0-
Revenue
Less:
Variable Costs
-Produce & Sell
8,800 17,600
-Costs of Goods Bought 9,600
-0Contribution Margin
$ 5,600 $ 6,400
Less Fixed Costs
3,840
4,800
Operating Profit
$ 1,760 $ 1,600
$(8,800)
9,600
$( 800)
(960)
$ 160
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Joint Products: Sell
or Process Further

As part of a single production process,
multiple products are produced

The point in the production process at
which identifiable products emerge is
called the splitoff point
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Costs incurred up to this point are called joint
costs
Costs incurred after the splitoff point are called
additional processing costs
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Joint Production Process
Additional
Processing Costs
Incurred
Joint Costs:
Direct Materials
Direct Labor
Overhead
Sale of
Product A
Sale of
Product B
Splitoff Point
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Adding or Dropping
Parts of Operations

General Rule: If differential revenue from sale
of a product > differential costs of providing
the product, then the product generates
profits and firm should continue production

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Even though product may show a loss on financial
statements due to overhead allocation to the
product
This rule applies to short-run decisions

If more profitable uses of the facilities can be
found, it may outweigh the contribution margin
lost by dropping a product
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Inventory
Management Decisions
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Inventory management affects
profitability

Having correct amount and type of
inventory can:
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Prevent production shutdowns
Avoid lost sales
Inventory is costly to maintain

Costs include storage, insurance, losses from
damage and theft, property taxes, etc.
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Differential Costs
for Inventory Management
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Two opposing costs to consider
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Setup or order costs - costs of setting up
machinery for a production run or costs to process
a purchase order
Carrying Costs - e.g., cost of maintaining
warehouse facilities
Management would like to find the optimal
trade-off point between these two costs
 Called the economic order quantity (EOQ)
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Estimating Costs of
Maintaining Inventory
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Differential Costs to consider include:
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Order costs - costs of salaries, lost time for
production setups, receiving and inspecting
orders, processing invoices, and freight
costs
Carrying costs - insurance, inventory taxes,
opportunity cost of funds invested in
inventory, additional warehouse space
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Just-in-Time

JIT is a method of managing
purchasing, production, and sales
where the firm attempts to:
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(Slide 1 of 2)
Produce items only as needed for the next
step in the production process, or
Time purchases so items arrive just in time
for production or sale
Can substantially reduce inventory
levels
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Just-in-Time
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(Slide 2 of 2)
Requires lay out of production process
so there is a continuous flow once
production starts
Requires reliable processing systems
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Linear Programming

Managers may face short-run
constraints in production resources such
as factory capacity, personnel time,
floor space, etc

Linear programming is used to address
production decisions involving limited
resources

Referred to as a constrained optimization
technique
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Economic Order Quantity

Can be determined through trial and error or
use the following formula: N=D/Q
Where: Q =
2 K 0 D / Kc
N = optimal number of orders
Q = economic order quantity
D = period demand
K0= order or setup cost
Kc= cost of carrying one unit in
inventory
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If you have any comments or suggestions concerning this
PowerPoint Presentation for Managerial Accounting, An
Introduction To Concepts, Methods, And Uses, please contact:
Dr. Donald R. Trippeer, CPA
donald.trippeer@colostate-pueblo.edu
Colorado State University-Pueblo
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