Short-Term Decision Making - Differential Analysis

Summary :

This chapter compares the contribution margin income statement to the traditional income statement format and introduces differential analysis as a framework for short-term decisions. It covers using differential analysis for pricing decisions, accepting or rejecting special orders, eliminating or adding product lines, choosing whether to process joint products further, and make-or-buy decisions.

Contribution margin format and differential analysis

The contribution margin income statement separates variable costs from fixed costs, in contrast to the traditional format, which separates manufacturing costs from selling and administrative costs, and this makes it far more useful for the short-term decisions covered in this chapter. Differential analysis compares the revenues and costs that differ between two or more alternatives, focusing only on those relevant differences rather than on costs that will be incurred regardless of which choice is made.

Special orders, product lines, and joint products

A special order below normal selling price can still be worth accepting if it uses otherwise idle capacity and the incremental revenue exceeds the incremental cost, since existing fixed costs are typically unaffected either way. Deciding whether to eliminate or keep a product line or segment requires examining whether that segment's own contribution margin covers its directly traceable fixed costs, and a joint product reaching its split-off point should be processed further only if the additional revenue exceeds the additional processing cost.

Make-or-buy and quality decisions

A make-or-buy decision compares the cost of producing a component internally, including only the costs that would actually be avoided by buying it, against the price of purchasing it from an outside supplier, while also weighing what else the freed-up capacity could be used for. Differential analysis can likewise support decisions to invest in improving product quality, by comparing the added cost of quality improvements against the value of the defects, returns, and lost sales they are expected to prevent.