1. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved. Differential Analysis: The Key to Decision Making Chapter 11 in Brewer

2. 10-2 Relevant Costs and Benefits A relevant cost is a cost that differs between alternatives. 1 2 A relevant benefit is a benefit that differs between alternatives.

3. 10-3 Identifying Relevant Costs An avoidable cost is a cost that can be eliminated, in whole or in part, by choosing one alternative over another. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs. Two broad categories of costs are never relevant in any decision. They include:  Sunk costs.  A future cost that does not differ between the alternatives. An avoidable cost is a cost that can be eliminated, in whole or in part, by choosing one alternative over another. Avoidable costs are relevant costs. Unavoidable costs are irrelevant costs. Two broad categories of costs are never relevant in any decision. They include:  Sunk costs.  A future cost that does not differ between the alternatives.

4. 10-4 Keys to Successful Decision-Making 1.Focus only on relevant costs (also called avoidable costs, differential costs, or incremental costs) and relevant benefits (also called differential benefits or incremental benefits). 2.Ignore everything else including sunk costs and future costs and benefits that do not differ between the alternatives.

5. 10-5 Now read ‘Cynthia’ Example (bottom of p393) Read bottom of page 393 as far as the end of the table on page 394 Depreciation on car? irrelevant Gasoline in New York relevant Car insurance and license irrelevant Repairs relevant Parking fees at School irrelevant

6. 10-6 Cynthia (continued) Wear and tear irrelevant Train ticket relevant Relaxing relevant but immeasurable Dog Kennel irrelevant

7. 10-7 Cynthia (continued) Car availabilityrelevant, but immeasurable Parking hasslerelevant, but immeasurable Now read the table on page 395

8. 10-8 Adding/Dropping Segments One of the most important decisions managers make is whether to add or drop a business segment. Ultimately, a decision to drop an old segment or add a new one is going to hinge primarily on the impact the decision will have on net operating income. To assess this impact, it is necessary to carefully analyze the costs.

9. 10-9 Page 400 Exhibit 11-2 (summarised) Should the housewares product line be dropped?. All $000’sDrugsCosmeticsHousewares Sales1257550 Variable expenses (50)(25)(30) Contribution755020 Fixed expenses (59)(38)(28) Net Operating Income 1612(8)

10. 10-10 Now read the table on page 401 Some if the fixed costs of the Housewares range are AVOIDABLE And some of them are UNAVOIDABLE Only the AVOIDABLE fixed costs are RELEVANT to the decision.

11. 10-11 Summary (figures in $k): Contribution margin of Housewares 20 Less avoidable fixed costs(15) Equals benefit of keeping housewares range 5 Conclusion: keep housewares range

12. 10-12 The Make or Buy Decision See Page 403 (bottom) Mountain Goat Cycles Total Cost per Unit of making ‘Gear-shifters’ $21 Outside Supplier offers them for $19 Should they accept? Not necessarily!

13. 10-13 The make or buy decision = see top of page 404 The ‘allocated’ general overhead of $5 per unit Is NOT RELEVANT to the decision! This is because it is unavoidable! So the RELEVANT unit costs of making gear shifters is $21 less $5 equals $16 This is less than the cost of buying-in ($19) so: MAKE

14. 10-14 Opportunity costs are RELEVANT Read bottom of page 405 and top of page 406 If Mountain Goat Cycles bought-in it would have SPARE CAPACITY If this spare capacity can be used to generate revenue Then this becomes an OPPORTUNITY COST See panel at top of Page 406

15. 10-15 ‘SPECIAL ORDER’ decisions A special order is a one-time order that is not considered part of the company’s normal ongoing business. When analyzing a special order, only the incremental costs and benefits are relevant. Since the existing fixed manufacturing overhead costs would not be affected by the order, they are not relevant.

16. 10-16 Limiting factor (limiting resource) When a limited resource of some type restricts the company’s ability to satisfy demand, the company is said to have a constraint. The machine or process that is limiting overall output is called the bottleneck – it is the constraint.

17. 10-17 Typical examples of limiting factors Limited availability of a special material or component Limited availability of skilled labour Limited availability of specialist equipment All of these are CONSTRAINTS on the number of units that can be produced (and therefore sold)

18. 10-18 Utilization of a Constrained Resource Fixed costs are usually unaffected in these situations, so the product mix that maximizes the company’s total contribution margin should ordinarily be selected. A company should not necessarily promote those products that have the highest unit contribution margins. Rather, total contribution margin will be maximized by promoting those products or accepting those orders that provide the highest contribution margin in relation to the constraining resource. Fixed costs are usually unaffected in these situations, so the product mix that maximizes the company’s total contribution margin should ordinarily be selected. A company should not necessarily promote those products that have the highest unit contribution margins. Rather, total contribution margin will be maximized by promoting those products or accepting those orders that provide the highest contribution margin in relation to the constraining resource.

19. 10-19 Constraints (limiting resources) See page 410 Mountain Pannier Touring Pannier Selling Price2530 Variable cost per unit (10)(18) Contribution per unit 1512 Monthly demand4,000 units7,000 units Stitching time per unit 2 minutes1 minute Total stitching time required 8,000 minutes7,000 minutes

20. 10-20 Constraints (limiting resources) MountainTouring Contribution per unit$15$12 Stitching time required per unit 2 minutes1 minute Contribution per minute of stitching time $7.50 per minute$12 per minute Therefore production of the TOURING pannier (and not the MOUNTAIN pannier) that should be prioritised