Differential Cost Analysis
Chapter 25
Management decisions

Accepting/Rejecting certain orders

Reducing the price of a single order

Making a price cut in a competitive market

Evaluating Make-or-buy alternatives

Expanding or reducing plant capacity

Increasing, curtailing or stopping production

Replacing present equipment

Spending additional amounts for sales promotion
Differential Cost

Difference between cost of alternative choices

Marginal/Incremental cost

Deals with determination of incremental
revenue, costs and margins

Variable costs are significant

Fixed costs might be included
Example
Total cost at 60,000 units = $324,250
 Total cost at 80,000 units = $423,400

Calculate total differential cost
 Calculate differential cost/unit

Solution
Differential cost = 423,400 – 324,250
= $99,150
 Differential cost/unit = 99,150/20,000
= $4.96

Accepting Additional Orders

Differential cost must be considered involving a
change in output

Difference between the cost of producing present
smaller output and that of the planned larger
output

Possibility of selling additional output at a figure
lower or greater than the existing average unit cost

New or additional business can be accepted as long
as the variable cost is recovered
Example
Maximum capacity=100,000 units
 Normal capacity = 80,000 units
 Variable cost per unit = $5
 Fixed cost= $100,000
 Sales price per unit= $9
 Profit at 80,000 and 81,000 units?

Solution
Present business


Sales
$720,000

Variable cost

Contribution

Additional business
Total
$9,000
$729,000
400,000
5,000
405,000
Margin
320,000
4,000
324,000

Fixed cost
100,000
_-0-____
100,000

Profit
320,000
4,000
224,000
Reducing the Price of a Special Order

At what minimum price the firm can
afford to sell additional goods
Example






Company manufactures 450,000 units using 90% of
its capacity
Fixed factory overhead is $335,000
Variable factory overhead = $0.50/unit
Direct materials = $1.80/unit
Direct labor = $1.40/unit
Each unit sells for $5
Example

Sales
$2,250,000

Cost of goods sold:

Direct materials(450,000*1.80)
810,000

Direct labor(450,000*1.40)
630,000

Variable factory overheads(450,000*0.50)
225,000

Fixed factory overheads(335,000*90%)
301,500

Income from operations
283,500

Unabsorbed fixed factory overheads(335,000*10%]
33,500

Income from operations (adjusted)
250,000
1,966,500
Special Order

Additional fixed cost if special order of
100,000 units is accepted = $10,000

Sales price of a special order=$4.25
Solution
Sales (100,000 units@4.25)
 Cost of goods sold:
 Direct materials(100,000units @1.80)
 Direct labor (100,000units @ 1.40)
 Variable factory overheads
 (100,000 units @0.50)
 Additional fixed cost
 Gain on the order
$425,000

180,000
140,000
50,000
10,000
380,000
$45,000
Exercise

The wood River plant of the Union Company has a normal
capacity 0f 90,000 units per month. Monthly production
costs are $12 variable cost per unit and $240,000 fixed. By
increasing the fixed cost $10,000 a month, the plant can
produce 95,000 units.

Differential cost of the production between 80% and 90%
of normal capacity.
Differential cost of producing the 5,000 units above the
normal capacity.
Per unit total production cost of the 95,000 units
Per unit differential production cost of the 5,000 units.



Solution

Differential cost of the production between 80%
and 90% of normal capacity.

90,000 units *90%
90,000 units *80%



81,000 units
72,000 units
9,000 units
9,000 units *$12 = $108,000
Solution

Differential cost of producing the 5,000
units above the normal capacity.
5,000 units *12
 Differential Fixed cost


$60,000
10,000
70,000
Solution

Per unit total production cost of the
5,000 units
95,000 units *12
$1,140,000
 Fixed costs(240,000+10,000) 250,000

1,390,000

Solution

Per unit differential production cost of
the 5,000 units.
=$70,000/5,000 units
 = $14

Exercise

Poppycrock,Inc., manufactures large crates of microwavable popcorn that are
typically sold to distributors. Their main factory has the capacity to manufacture
and sell 35,000 crates per month. The following information is available for the
factory:

Sales price per crate

Variable cost per crate:

Direct materials
4.50

Direct labor
10.50

Variable overhead
3.50

Fixed cost per month
$122,000
ABC of Canada offered to pay Poppycrock $20 per crate for the special
batch of 5,000 crates. The additional cost of label is estimated at $1 per
crate. In addition, the variable overhead for these special order crates
would decrease by $0.50 because there would be no distribution costs
for these special order crates .
What is the cost of creating a normal crate of popcorn? What is the
incremental cost of creating a special order crate of popcorn?


$24
Make-Or-Buy Decisions

Compare the cost of making the parts with the
cost of buying them

Costs for each of the alternatives must be
based on the identical product specifications,
quantities and quality standards
Decisions to Shut Down Facilities

In the short run, a firm seems to be better off
operating than not operating if revenue > variable
costs

Shutting down of facilities
◦
◦
◦
◦
Does not eliminate all costs
Loss of investment spent on training employees
Recruiting and training costs after reopening
Loss of losing established markets & customers
Decisions to Shut Down Facilities

If operations are continued
◦ Certain expenses connected with the shutting down
of the facilities can be saved
◦ Costs that would have to be incurred when a closed
facility is reopened will be saved
Decisions to Discontinue Products

Requires careful analysis of relevant differential cost
and revenue data

Following benefits can be achieved with the correct
decision:
◦
◦
◦
◦
Expanded sales
Increased profits
Reduced inventory levels
Resources made available for more promising
projects
Decisions to Discontinue Products

Not only the profitability of the products being
analyzed be considered but also the extent to which
sales of other products will be affected when one
product is removed should be evaluated
Decisions to Discontinue Products

Management needs following signals to identify
troubled products:
◦ Declining sales volume
◦ Decreasing market share
◦ Malfunctioning of the product or introduction of a superior
competitive product
◦ Expected future sales and market potential not favorable
◦ Return on investment below minimum acceptable level
◦ Variable costs approaching or exceeding revenue
◦ Price required to be constantly lowered to maintain sales
Other Cost Concepts

Opportunity costs
◦ Measurable value of an opportunity bypassed by rejecting an
alternative use to resources
◦ Measurement of sacrifices associated with alternatives

Imputed costs
◦ Hypothetical costs representing the cost/value of a resource
measured by its use value
◦ Interest on invested capital, rental value of company-owned
properties, salaries of owners of sole proprietors
◦ Do not involve actual cash flows
Other Cost Concepts

Out-Of-Pocket Costs
◦ Involves cash outlays
◦ Often identified as variable costs
◦ Helpful in deciding whether a particular venture will
at least return the cash expenditures

Sunk Costs
◦ Irrecoverable costs
◦ Not included in differential cost analysis