Differential Analysis
and Product Pricing
Chapter 12
Identification of Relevant Costs and
Revenues for Decision Making

A relevant cost (revenue) is a cost (revenue)
that can have an impact on a decision

Characteristics of relevant costs (revenues)

Cost (revenue) that varies between alternatives

Incremental or differential cost (revenue)

Occur in the future

Opportunity costs

Benefit given up when one alternative is chosen over
another
Identification of Relevant Costs and
Revenues for Decision Making

Sunk cost

A cost that has already been incurred

Always irrelevant because it cannot be changed
Differential or Incremental Analysis

Analysis of the differences in revenues and
costs between alternative courses of action

Typical applications






Sell an unused asset, or keep it and lease it to
someone else
Discontinue a product or segment, or continue it
Make a component or purchase it from a supplier
Keep existing equipment or replace it
Sell a product as it is, or process it further
Accept business at a special price
Applications of Incremental Analysis

Sell or lease

Relevant items


Sell alternative

Potential sales price, if any

Cost to dispose of the item
Lease alternative

Lease revenue

Maintenance costs, insurance, property taxes, etc. if
they will continue to be paid by us
Applications of Incremental Analysis

Discontinue a product or segment

Relevant items

Amount of revenue that will be lost if the product or
segment is discontinued

Amount of cost that can be avoided if the product or
segment is discontinued

If the amount of cost that can be avoided exceeds the
lost revenue, it is financially wise to discontinue the
product or segment
Applications of Incremental Analysis

Make or buy a component

Relevant items


Make alternative

Incremental costs (direct materials, direct labor, variable
overhead)

Fixed overhead is irrelevant if it does not increase as a
result of the additional production
Buy alternative

Purchase price from supplier

Alternative uses for the manufacturing capacity that
becomes available
Applications of Incremental Analysis

Keep existing equipment or replace it


Relevant items

Difference in operating costs between the existing and
proposed equipment

Any change in revenue that may result from increased
(or decreased) capacity

Purchase price of the new equipment (included in the
operating costs as depreciation)

Sales value, if any, of the current equipment
The original cost of the current equipment is
irrelevant as it has already been incurred
Applications of Incremental Analysis

Sell a product now or process further

Relevant items

Incremental cost to process the item further

Incremental revenue if the item is processed further

If the incremental revenue exceeds the incremental cost,
it is financially wise to process the product further
Applications of Incremental Analysis

Accept business at a special price

Relevant items

Sales price to be received for the items

Incremental costs to be incurred producing the items
(direct materials, direct labor, variable overhead)

Fixed overhead is irrelevant if it does not increase as
a result of the greater production
Product Pricing Under Production
Constraints

The contribution margin per unit provides
some guidance as to which products should
be produced


Emphasis should be placed on the item with the
largest contribution margin
If there are production constraints (limited
amount of resources), we must consider the
demands each product places on the
resources
Product Pricing Under Production
Constraints

Produce those products that generate the
greatest contribution per unit of the
constraining resource
Contribution margin per unit
Amount of constraining
resource required per unit
Contribution per unit of the
constraining resource
Product A
$ 120.00
Product B
$
60.00
Product C
$
48.00
20
8
6
$
6.00
$
7.50
$
8.00