A single raw material input that can be separated into one or more materials is known as a joint product. The point at which the original raw material input is separated into more than one output is known as the split-off point. Several oil products, including gasoline, jet fuel, lubricants, petroleum jelly, and other chemicals, are extracted during the refinement process. Differential decision making can be used to analyze the effect of selling the by-products created at the split-off point versus processing the by-products further before selling them. If the shiitake product line is dropped, Shrooms can grow and sell an additional 45,000 lbs.

Video Illustration 10-1: Add or drop a segment LO3

Take a close look at Figure 7.1 before reading the description of this information that follows. Differential decision making can be used to analyze the decision to sell a by-product as is or to process it further. The example of Shrooms, an organic mushroom farm, is continued to illustrate a sell or process further decision. Approximately 10% of both species of mushrooms will not comply with commercial standards in terms of caliber, shape, or size. Irregular mushrooms cannot be sold through the company’s regular sales channels. Carlos can sell the irregular mushrooms, as is, to a food co-packer that uses the mushrooms in a commercial soup product.

Special Order Considerations

This cost differs between the alternatives, so it is relevant to this decision. In other words, Kendra can avoid the cost of purchasing groceries if she decides to go out to dinner. Relevant https://www.business-accounting.net/ costs or benefits are defined as costs or benefits that differ between alternatives. If a cost or benefit does not differ between alternatives, it is not considered relevant to the decision.

7.2 Using Differential Analysis to Make Decisions

For example, rent paid for Barbeque Company’s retail store is allocated to all three product lines because it is not easily traced to each product line. However, the retail store rent likely will not decrease if the charcoal barbecues product line is eliminated (unless the company chooses to move to a smaller, less costly store). The charcoal barbecues’ allocation for rent would simply be reallocated to the other two products.

What is Incremental Analysis?

In making any pricing decision, management should seek the combination of price and volume that produces the largest total contribution margin. This combination is often difficult to identify in an actual situation because management may have to estimate the number of units that can be sold at each price. Certain costs will be incurred whether there is an increase in production or not, which are not computed when determining incremental cost, and they include fixed costs.

What Is Incremental Analysis?

Thus rent for the retail store is an example of an allocated fixed cost that is not a differential cost for the two alternatives facing Barbeque Company. When applying differential analysis to pricingdecisions, each possible price for a given product represents analternative course of action. The sales revenues for eachalternative and the costs that differ between alternatives are therelevant amounts in these decisions. To illustrate, assume that the Campus Bookstore is considering eliminating its art supplies department. If the bookstore dropped the art supplies department, it would lose revenues of $100,000 annually.

Benefits of Incremental Cost Analysis

For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. He is the sole author of all the materials on AccountingCoach.com. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. It enables businesses to streamline operations, eliminate waste, and concentrate on areas where cost savings can make a big difference. Businesses can choose wisely by weighing the varying costs involved with each option against the anticipated advantages (like higher revenue or cost savings). Businesses looking to maximize efficiency and profitability must thoroughly understand these costs and how they operate.

Forexample, suppose eliminating a part would reduce production so thata supervisor’s salary could be saved. In such a situation, firmsshould treat these fixed costs the same as variable costs in theanalysis because they would be relevant costs. An organization can make a product or perform a function internally, or the organization can purchase the product or service from an external supplier. Evaluating this decision is traditionally known as a make or buy analysis. Make or buy decisions are considered differential decisions since only relevant costs and benefits are considered. While it is referred to as a make or buy decision, it is also used to analyze performing an activity internally versus outsourcing the activity to an outside supplier.

The opportunity cost of attending school is the lost wages from working. Notice that in Figure 4.1 “Differential Analysis for Phillips Accountancy” the columns labeled Alternative 1 and Alternative 2 show revenues, costs, and profit for each alternative. The third column, labeled Differential Amount, presents the differential revenues and costs and resulting differential profit. Positive amounts appearing in this column indicate Alternative 1 is higher than Alternative 2.

1. Differential revenues and costs (also called relevant revenues and costs or incremental revenues and costs) represent the difference in revenues and costs among alternative courses of action.
2. The organizer plans to sell promotional meal kits with all the ingredients to make a healthy meal at home.
3. Financial managers conduct a comparative analysis to ascertain the difference in the cost due to the change in operations.
4. It is a useful tool for making strategic decisions in various business contexts.
5. The following monthly segmented income statement is for Thirst Quench, a maker of soda, sports drink, and lemonade.
6. It identifies potential changes in revenues and costs that arise from the existing alternative and choose that which will result in the highest net income or the lowest price.

Traceable and common fixed costs are discussed in detail in Chapter 5, Segment Income Reporting. Management can use differential analysis to decide whether to process a joint product further or to sell it in its present condition. Joint costs are those costs incurred up to the point where the joint products split off from each other.

When the differentialrevenue of further processing exceeds the differential cost, firmsshould do further processing. As concerns increase about theeffects of waste on the environment, companies find more and morewaste materials that can be converted into by-products. Management can use differential analysis todecide whether to process a joint product further or to sell it inits present condition. Joint costs are those costsincurred up to the point where the joint products split off fromeach other. These costs are sunk costs and are not considered whendeciding whether to process a joint product further before sellingit or to sell it in its condition at the split-off point.

The method incorporates accounting and financial information in the decision-making process and allows for the projection of outcomes for various alternatives and outcomes. Through incremental analysis, the revenues, costs, and possible outcomes of the alternatives can be identified. We will build upon the differential analysis format shown in Figure 7.1 throughout this chapter, and show how more detail can easily be provided using the same format. Companies use this same form of differentialanalysis to decide whether they should discard their by-products orprocess them further. Forexample, the bark from trees cut into lumber is a by-product oflumber production. Although a by-product, companies convert thisbark into fuel or landscaping material.

Her position would be eliminated if the nails product line is dropped. The remaining expenses are general expenses and would not be eliminated. The example of Shrooms, an organic mushroom farm, is continued to illustrate a make or buy decision. Currently, Shrooms is purchasing organic compost from an outside supplier. He wants to determine if it is more profitable to buy the compost from an external supplier or make it on the farm.

Determination of the most profitable level of production and price. Differential cost is the change in cost that results from adoption of an alternative course of action. It can be determined simply by subtracting cost of one alternative from cost of another alternative or from the cost at one level of activity, the cost at another level of activity. Marginal analysis usually disregards any past or sunk cost, and it is useful when working on a business strategy such as to outsource a function or self-produce it.

It also takes into account sunk, or non-relevant costs, and excludes those from analysis. The concept of sunk costs describes a cost that’s already been incurred and does not impact any decision made by management or between alternatives. The cost is unlikely to increase in the future or disappear completely. Other terms that refer to sunk costs are sunk capital, embedded cost, or prior year cost.

Allocated costs are typically not differential costs, and therefore are typically not relevant to the decision. Relevant costs are also referred to as avoidable costs or differential costs. For a cost to be considered a “relevant cost,” it must be incremental, result in a change in cash flow, and be likely what is the reciprocal of 7 to change in the future. Hence, a relevant cost arises due to a particular management decision. The concept does not apply to financial accounting but can be applied to management accounting. In some manufacturing situations, firms avoid aportion of fixed costs by buying from an outside source.

For example, the differential amount of $1,000,000 for revenue indicates Alternative 1 produces $1,000,000 more in revenue than Alternative 2. The differential amount of $750,000 for variable costs indicates variable costs are $750,000 higher for Alternative 1 than for Alternative 2. Move to the bottom of Figure 4.1 “Differential Analysis for Phillips Accountancy”. Notice that the differential amount for profit is negative ($20,000).

Differential analysis requires that we consider all differential revenues and costs—costs that differ from one alternative to another—when deciding between alternative courses of action. Avoidable costs—costs that can be avoided by selecting a particular course of action—are always differential costs and must be considered when deciding between alternative courses of action. In many situations, this increased allocation to other product lines may cause other product lines to appear unprofitable. The message here is to be careful when analyzing segmented information containing cost allocations.