Chapter 10 - Differential Decision Making
Summary :What Is Differential Decision Making
Managers constantly choose between competing alternatives - which products to offer, whether to make a component in-house or buy it, whether to accept a one-time order at a discounted price. Differential decision making is the discipline of comparing only the costs and benefits that actually differ between those alternatives, and then choosing whichever alternative produces the better financial outcome. The key insight is that a cost or benefit that stays exactly the same no matter which alternative is chosen contributes nothing to the decision, so a manager who wants a clear answer has to strip those identical costs out of the analysis rather than let them clutter the comparison.
Relevant vs. Irrelevant Costs
A relevant cost or benefit is one that differs between the alternatives being compared; an irrelevant cost is one that stays the same regardless of which choice is made. Relevant costs are also called avoidable costs, because they can be avoided by choosing one alternative over another. Sunk costs - money already spent before the decision point - are always irrelevant, because no future choice can undo a cost that has already been incurred. Suppose a woodworking shop already owns a $6,000 lathe it bought two years ago; whether the shop decides to take on a new furniture line or not, that $6,000 was spent regardless, so it plays no role in the new decision. Fixed costs need particular care in this kind of analysis, because they split into traceable fixed costs (costs that belong to one specific segment and would disappear if that segment were eliminated - these are relevant) and common fixed costs (costs shared across segments that continue no matter what - these are irrelevant unless the decision specifically eliminates them).
Add or Drop a Segment - Worked Example
Suppose Riverside Bakery sells two product lines, sourdough loaves and rye loaves, and the rye line's segmented income statement shows a $9,200 net loss for the quarter, prompting the owner to consider dropping it. On the surface it looks like dropping rye would add $9,200 to overall profit, but that conclusion ignores which of the rye line's costs would actually disappear. Suppose the rye line's $9,200 loss includes $42,000 of traceable variable costs and $31,000 of fixed overhead allocated based on sales dollars, of which only $6,500 is actually traceable to the rye ovens and staff scheduling and would be eliminated if rye were dropped - the remaining $24,500 is common building and equipment cost that would simply shift onto the sourdough line. If dropping rye also frees up oven capacity that lets the bakery sell an additional $18,000 of sourdough at a 45 percent contribution margin ratio, that adds $8,100 in extra contribution margin. Adding up only the relevant pieces - the lost contribution margin from rye sales, the $6,500 in avoided traceable fixed costs, and the $8,100 in additional sourdough contribution margin - produces the true financial effect of dropping the segment, which will typically look very different from simply eliminating the segment's reported net loss.
Make or Buy (Outsourcing) - Worked Example
A make or buy decision compares the cost of producing a component or performing a function internally against the cost of purchasing it from an outside supplier, and it applies just as well to physical parts as to services such as payroll processing. Suppose a furniture maker currently buys metal drawer pulls from a supplier for $2.40 each and uses 9,000 pulls a year, and is considering making them in-house instead. Making them requires $1.10 per unit of raw metal stock and $0.35 per unit of electricity for the stamping press, both of which are new, relevant costs. The shop has an idle employee who could run the stamping press during existing paid hours at no additional payroll cost, so labor is irrelevant to the decision since it would be paid regardless. The relevant cost to make the pulls is $1.45 per unit ($1.10 material plus $0.35 electricity), which is $0.95 cheaper per unit than the $2.40 purchase price, producing a projected annual saving of $0.95 times 9,000 units, or $8,550, from making the pulls in-house - provided the shop's existing overhead and equipment truly require no additional outlay.
Special Order Decisions - Worked Example
A special order is a one-time sale outside an organization's normal sales channel, typically at a price below the regular selling price, and the decision to accept it hinges on whether the order price covers the relevant (avoidable) cost of producing it - not the full cost including fixed overhead that would be incurred anyway. Suppose a candle maker's normal retail price is $9.00 per candle, with variable production cost of $3.20 per candle (wax, wicks, fragrance, and labor) and fixed overhead allocated at $1.80 per candle based on normal volume. A community fundraiser asks to buy 400 candles at a discounted $4.50 each, well below the $9.00 regular price. Because the candle maker has spare production capacity and the order will not displace any regular sales, the $1.80 of fixed overhead is irrelevant - it would be incurred regardless of whether the special order is accepted. Comparing only the relevant figures, the $4.50 special order price exceeds the $3.20 relevant variable cost by $1.30 per candle, so accepting the order adds $1.30 times 400 candles, or $520, to profit, even though the order price sits well below the regular selling price and below the candle's fully allocated cost of $5.00.
Sell or Process Further (Joint Products)
When a single raw material is processed to the point where it splits into two or more distinct products - the split-off point - a manager must decide whether to sell each resulting product as is or process it further before selling it. Costs incurred up to the split-off point are joint costs, and because they have already been spent to get all of the products to that point regardless of what happens afterward, joint costs are always irrelevant to the sell-or-process-further decision; they behave exactly like sunk costs. Only the additional processing costs incurred after the split-off point, compared against the additional revenue that further processing generates, are relevant. Suppose a juice company presses oranges into juice and is left with 20,000 pounds of pulp as a by-product each month. The pulp can be sold as is to a livestock feed company for $0.35 per pound, or it can be dried and ground into a fiber powder that sells for $1.10 per pound, requiring $9,000 of additional drying and packaging cost and yielding one pound of powder for every four pounds of fresh pulp (5,000 pounds of powder from the 20,000 pounds of pulp). Selling the pulp as is generates 20,000 times $0.35, or $7,000. Processing it further generates 5,000 times $1.10, or $5,500, minus the $9,000 processing cost, for a net of $(3,500) - a $10,500 disadvantage compared to selling the pulp as is, so the juice company is financially better off selling the pulp unprocessed despite the higher per-pound price the powder commands.
Quick Revision Summary
Differential decision making compares only relevant costs and benefits - those that differ between alternatives - and ignores irrelevant costs, including all sunk costs, which cannot be changed by any future decision. In add-or-drop decisions, only traceable fixed costs that would actually be eliminated are relevant; common fixed costs that continue regardless are not. In make-or-buy decisions, only costs that would actually change (such as new materials or new equipment) are relevant, while costs the organization would incur either way (such as an already-idle employee's existing salary) are not. In special order decisions, fixed overhead already covered by normal volume is typically irrelevant if the special order uses spare capacity, so the order should be accepted whenever its price exceeds the relevant variable cost per unit. In sell-or-process-further decisions, joint costs incurred before the split-off point are always irrelevant sunk costs; only the incremental revenue and incremental processing cost after the split-off point determine whether further processing pays off.