Managerial Accounting
Class Notes and Lecture Outline
Differential Analysis
The contribution margin format separates fixed costs from variable costs; the traditional method does not.

The contribution margin format reports total contribution margin; the traditional method reports gross margin. In a manufacturing company:
  • Contribution margin = Revenue - Variable Manufacturing Costs - Variable Nonmanufacturing Costs.
  • Gross margin = Revenue - Cost of Goods Sold, where cost of goods sold = variable manufacturing cost of goods sold + fixed manufacturing cost of goods sold.
Differential analysis involves analyzing the different costs and benefits arising from alternative solutions to the situation.
  1. Relevant costs and revenues are those that differ between alternatives. Future costs that do not differ between alternatives are irrelevant and may be ignored since they affect both alternatives similarly.
  2. Differential cost is the amount by which relevant costs differ between two alternatives. Differential revenue is the amount by which relevant revenues differ between two alternatives.
  3. Sunk costs are past costs about which management can do nothing in the future. These costs are irrelevant to decision making.
  4. Committed fixed costs relate to the facilities or organizational structure that a company must have to continue operations. Discretionary fixed costs are subject to management control from year to year.
  5. Opportunity cost is the potential benefit that is foregone from not following the best alternative course of action.
The alternative resulting in the greatest positive difference between future revenues and future expenses (costs) should be selected when using differential analysis.

In establishing short-run prices, the goal is to select that price at which total future revenues will exceed total future variable costs by the greatest amount. This choice will result in the greatest total contribution margin.
Under certain conditions a product may be sold at two or more different prices in different markets.
  1. This possibility may enable management to minimize the risk of loss from having idle personnel and plant capacity.
  2. Only the differential cost of producing the items needs to be matched against the differential revenue provided when deciding whether to accept an offer at lower-than-normal price (average costs should be ignored).
  3. If the differential cost is lower than the differential revenue, the offer should be accepted unless there is an alternative use for the facilities that would be even more profitable.
  4. Variable costs set a floor for the selling price.
Special cost and revenue studies may be called for to assist management in making decisions concerning adding or dropping given products, segments, or services to certain customers.
  • If differential revenue exceeds differential cost (usually only the difference in future variable costs), the product is making a contribution to income and should be retained.
  • Normally, fixed costs will remain unaffected, and therefore would not be relevant to the decision.
  • If an alternative use of the facilities would produce future revenues that would exceed future costs by more than the current use of those facilities, a change to the alternative should be made.
In deciding whether to further process a joint product, the future revenues and costs should be compared.  If the differential revenue exceeds the differential cost, further processing should take place before sale.  The same analysis is valid in deciding whether by-products should be discarded or processed further.
Differential analysis can also be used in make-or-buy decisions. [E6-8]
  • The price that would be paid for the part if it were purchased must be compared with the additional costs that would be incurred if the part were manufactured (including the opportunity cost of not using the space and facilities in their best alternative use).
  • Other factors such as the competency of existing personnel, availability of working capital, quality requirements, and borrowing costs should be considered.
High quality improves the company’s prospects for maintaining or even increasing its market share in years to come. Quality should be improved if the differential revenues are greater than the differential costs given the long-term effect the decision will have on demand.

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last updated January 15, 2011