Chapter 2 Differential Analysis: The Key to Decision Making

Chapter definitions

A relevant cost is a cost that differs between alternatives

A relevant benefit is a benefit that differs between 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.

Incremental cost—the additional total cost incurred for an activity

Differential cost—the difference in total cost between two alternatives

Incremental revenue—the additional total revenue from an activity

Differential revenue—the difference in total revenue between two alternatives

An opportunity cost is the benefit that is foregone as a result of pursuing some course
of action.

Opportunity costs are not actual cash outlays and are not recorded in the formal
accounts of an organization.

A special order is a one-time order that is not considered part of the company’s normal
ongoing business.

the company is said to have a constraint: When a limited resource of some type restricts
the company’s ability to satisfy demand, the company is said to have a constraint.

the bottleneck: The machine or process that is limiting overall output

 Increasing the capacity of a constrained resource should lead to increased

production and sales

Joint products: Two or more products produced from a common input

the split-off point: The point in the manufacturing process where each joint product can
be recognized as a separate product

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  Two broad categories of costs are never relevant (irrelevant ) in any decision
include:

Sunk costs: have already been incurred and cannot be avoided.

 Sunk costs are excluded because they can not be changed by future actions.
 These are costs that were incurred in the past and are not recordable.

EX: The depreciation represents a sunk cost.

Future cost: does not differ between the alternatives and is never relevant in a decision.
The general factory overhead represents future costs that will be incurred.

 How can the manager manage constraints?

It is often possible for a manager to increase the capacity of a bottleneck, which is called
relaxing (or elevating) the constraint, in numerous ways

1. Working overtime on the bottleneck.

2. distribute some of the processing that would be done at the bottleneck.

3. Investing in additional machines at the bottleneck.

4. Shifting workers from non-bottleneck processes to the bottleneck.

5. Focusing business process improvement efforts on the bottleneck.

6. Reducing defective units processed through the bottleneck.

 What are The Pitfalls of Allocation?

Joint costs are traditionally allocated among different products at the split-off point.

A typical approach is to allocate joint costs according to the relative sales value of the
end products.

allocation is needed for some purposes such as balance sheet inventory valuation.

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 Chapter Questions
1. Future costs that do not differ among the alternatives are not relevant in a
decision. TRUE
2. Fixed costs are irrelevant in a decision. FALSE
3. Sunk costs are considered to be avoidable costs. FALSE
4. Avoidable costs are also called relevant costs. TRUE
5. An avoidable cost is a cost that can be eliminated (in whole or in part) as a result
of choosing one alternative over another. TRUE
6. A sunk cost is a cost that has already been incurred and that cannot be avoided
regardless of what action is chosen. TRUE
7. bThe book value of a machine, as shown on the balance sheet, is relevant in a
decision concerning the replacement of that machine by another machine. FALSE
8. If by dropping a product a firm can avoid more in fixed costs than it loses in
contribution margin, then the firm is better off economically if the product is
dropped. TRUE
9. Generally, a product line should be dropped when the fixed costs that can be
avoided by dropping the product line are less than the contribution margin that
will be lost. FALSE
10. The cost of a resource that has no alternative use in a make or buy decision
problem has an opportunity cost of zero. TRUE
11. Depreciation expense on existing factory equipment is generally relevant to a
decision of whether to accept or reject a special offer for a company's product.
FALSE
12. When a company has a production constraint, the product with the highest
contribution margin per unit of the constrained resource should be given highest
priority. TRUE
13. Managers should not authorize working overtime at a work station that contains
a bottleneck. FALSE
14. Joint costs are not relevant to the decision to sell a product at the split-off point
or to process the product further. TRUE
15. Joint production costs are relevant costs in decisions about what to do with a
product from the split-off point onward in the production process. FALSE
16. Costs which are always relevant in decision making are those costs which are:
A. variable. B. avoidable. C. sunk. D. fixed.

17. A general rule in relevant cost analysis is:

A. variable costs are always relevant. B. fixed costs are always irrelevant.
C. differential future costs and revenues are always relevant. D. depreciation is
always irrelevant.
18. The opportunity cost of making a component part in a factory with no excess
capacity is the:

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A. variable manufacturing cost of the component. B. fixed manufacturing cost
of the component. C. total manufacturing cost of the component. D. net
benefit foregone from the best alternative use of the capacity required.