The differential analysis i

The differential analysis is the study/analysis of differential revenues and costs. What are differential revenues and costs, though? Differential revenues and costs are the revenues and costs that will differ (the ones that will change) when making the comparison between two or more things (products, customers, etc.). That being said, all the revenues and costs that can be associated to one specific product, customer or service, if they change between from one alternative to the other, then they are considered to be differential and they will be taken into account during the differential analysis.

In order to decide whether a customer, a product line, or a service, will be kept or dropped, or if a product will be manufactured, or its production outsourced, a differential analysis must be made. The differential analysis will segregate the revenues and costs, and then calculate the difference between them. It is important to note that the costs must be classified as fixed costs (or allocated fixed costs), when they do not change as a result of the decision made to keep or drop a product line or customer, produce or buy something; and variable costs (differential costs), which are the costs directly assigned to a product (or its production), customer, service, or product line.

A very important information/data on this process is that all fixed costs that cannot be traced directly to customers or products will then be allocated (re-distributed) to all customers or products, which means they will be considered as fixed costs and not as differential costs. For example, a warehouse used specifically to stock a product. The rental or lease obligations will remain even if the production is stopped.

Besides all these data (fixed/variable costs, revenues, etc.), that are classified as “quantitative information”, there are also the ones that are called “qualitative information” that, on the other hand, are the information that cannot be measured, such as opinions, beliefs, prestige, reputation, etc. We will a little more about them later in this article.

Now that we know what is the basic information that we need, in order to do the differential analysis, then let’s see some practical examples.

 

Drop/Keep Customers: When a company has one customer who’s resulting in a loss for the business, it not that easy to determine whether this customer must be dropped or kept, in order to increase the overall profit, or to avoid decreasing the current profit numbers. There are fixed costs that can be traced directly to customers, and they are considered differential costs during the differential analysis process. There are fixed costs, however, that cannot be traced by customers so they are classified as allocated costs and are considered fixed costs (not differential), and even if a customer is dropped they will remain the same. The only difference is that they will be redistributed to the remaining customers.

See the examples below: Notice that the customer 2, who gives a loss for the company has been dropped in three different scenarios.

In the first scenario, if the customer 2 is dropped, then the overall profit will reduce from $10.00 to $0.00. It is advisable then to keep the customer 2, even if it gives a loss of $20.00 itself. Customer 2 helps to pay the fixed costs, resulting in an overall profit of $10.00. Some would say that customer 2 helps to pay the bills.

In the second illustration, if the customer 2 is dropped, then the overall profit will increase. In this case, it is advisable to drop it. It causes more losses than it contributes to cover the fixed costs. Customer 2 in this scenario, besides giving a loss, also avoids the company to increase its overall profits.

In the third example, regardless the decision made, it will not affect the company’s overall results. Note that the overall profit remains at $5.00. In this case, besides using quantitative information, that is shown in the table, some qualitative information may be used. Is there any benefit to the community if customer 2 is kept? Any benefit to the society? Is customer 2 promoting the good image of your company? If the answer for these, and perhaps, a couple of other questions is “YES” then keep it, otherwise drop it. The decision in such a case will most likely to be taken based on a qualitative data.

With these three examples, it is easy to see how the differential analysis is important in a decision-making process, and also how quantitative and qualitative information may be used or have influence in the decision-making process.

 

Product Line Offerings: In order to determine the viability of any business there are some data that must be known (or at least, projected). They are the sales revenue, the variable, and the fixed costs. From these data, all the other numbers will be derived. Once you have the fixed costs, then you have to analyze whether they can be allocated to the product line (differential costs) or if they are fixed costs that will remain regardless the decision made. With these numbers, by doing the differential analysis you can easily determine which option will be the best one for the company.

It is important to mention that, if a company produces 10 different items, then the total fixed costs (employees salaries, building rent, machinery, etc.) will be allocated to all products based on their sales revenues (or in some cases, on their production numbers). If any of the products are dropped then its allocated fixed costs will be re-assigned to the remaining 9 products, which means their allocated fixed costs will increase. Taking into consideration that the sales revenue for the dropped product will disappear and that the allocated fixed costs will remain the same (in total) does not mean that dropping that product is the best option. It is necessary to analyze the data (incremental or differential analysis) prior to making any decision. Exceptions will be treated later.

See the examples below: Notice that there are three scenarios, each one with its numbers in revenues and costs.

In the first example, if the company decides to stop offering skates, its profit will decrease from $10.00 to $0.00, which means that even with a loss, since the skate is contributing to pay the bills, the company will better off keeping its skate production line.

The second table demonstrates that, in case the skates are not produced anymore, the profit will increase from $10.00 to $20.00. Here, its fixed costs are so high that the company will better off stopping its production line. It does not help to pay the bills, it actually increases the overall expenses.

The third scenario shows that the overall profit for the company will remain the same whether or not the skates are produced. In this scenario, there is again the possibility of a qualitative data analysis in order to determine whether or not to keep this product line. Since it does not hurt the company’s overall profit, then the impact it has on the local community, on the company’s image or reputation, will most likely to be the key decision makers.

 

Make-or-Buy Decisions: The differential analysis will compare all the costs associated with the production of a given product versus all the costs associated with outsourcing the same product. It will consider not only the variable costs but also the fixed costs for the final decision.

In some cases, it will be possible to eliminate all the fixed costs, whilst in some others that will not be possible, so a differential analysis has to be performed and the decision made based on the results of the differential analysis.

See the examples below: Three scenarios have been demonstrated.

As you can see, in the first scenario, buying the product will result in a total of $850.00 whilst it will cost $900.00 to be produced, then it is clear that the company will better off buying the product it needs.

In the second example, on the other hand, the total costs of buying the product will increase. It is explained by the fact that some fixed costs will remain (and in some cases because the cost of the product is relatively high when it is bought). In this situation, the company will better off manufacturing this product.

For the third calculation, regardless of the option chosen, the total costs will remain at the same level. The quantitative information is not enough in the decision-making process. The qualitative data may take place then. For example, is the quality of the “bought” product at the same standards as the ones the company produces? Will the company generate jobs by producing its goods? Will this decision have any effect on the local community, society, etc.? The company will most likely take this information into account to help in the decision-making process.

 

Quantitative x Qualitative Information

Even though most of the information used for differential analysis is quantitative (as revenues and costs), there is also qualitative information to be considered. Sometimes they play an equally important role in the business decision. If the quantitative numbers show that the company may profit from something, but qualitatively speaking, it may lead the company to either lose its employees, face legal issues, lose their product quality or reputation, or even affect negatively the society, then the company may use the qualitative information to make a final decision. 

For some companies, the reputation, employees morale, and their image and reputation play the most important role in this game, and they will certainly interfere in the results of a differential analysis. Actually, the company may disregard the differential analysis results based on their beliefs and opinions.

Another good example is when management believes that the sales will either increase or decrease, affecting directly its capacity or flexibility. These are important information that must be taken into account. Will the supplier (or the company) be able to supply an increasing demand in production? Will the company (or the supplier) have the flexibility it needs in case the sales decrease?

Sunk and Opportunity Costs

There are also two important concepts to be taken into account in this decision-making process. They are the sunk and opportunity costs.

Sunk costs are considered fixed costs (not differential) that cannot be eliminated or changed. They are costs acquired in the past that will remain in the future. A building or machinery acquired (and already paid) or an insurance (already paid) are some examples of sunk costs. Sunk costs should never affect a future decision. They are not relevant costs, and for that reason, should not be taken into consideration for decision making. The sunk cost is irrelevant to decision making because it has already been incurred. There is nothing to do about it regardless of the decision made.

Opportunity costs – that are differential costs - are the benefits foregone when a company chooses one alternative over another. For example, if a company is evaluating the possibility of either keeping or dropping a production line, then it will face the following situation. Imagine that the space occupied by the production line in question can be rented in case the production line is deactivated (dropped), then the opportunity cost of keeping it is the amount of money possibly earned with its rent. Opportunity cost is the benefit that you give when making a choice. Another example: Imagine that you want to start your own company, but in order to do that, you have to quit your job. Then the opportunity cost for you to start your own business will be your salary that you will give up, you will no longer have it.

 

With all that being said, why a managerial decision may be made, at times, that doesn’t align with the quantitative recommendations of the analysis? That’s a really interesting question and the best answer is because there are some other important facts like beliefs, values, convenience, prestige, morale, and environmental considerations, for instance. If all the numbers show that the business will bring a great profit but the environment can be damaged, causing the society to argue/fight against your company, leading to damages to your company's image, the qualitative data may overcome the quantitative information. Ethical issues also play an important role in this aspect. They may have a huge weigh in the decision making processes.

Another point is that quantitative data do not demonstrate the financial condition of your chosen supplier, for example, and for a robust decision-making process, this data cannot be neglected. What happens if you sell all your stuff, fire your employees, and your supplier just closes its doors? The best decision, as in any other sectors, will be a mix of quantitative – that is essential – and qualitative – that is very important – data.

 

References

Cliffs Notes, Examples of Incremental Analysis. Retrieved Feb 24, 2018, from https://www.cliffsnotes.com/study-guides/accounting/accounting-principles-ii/incremental-analysis/examples-of-incremental-analysis

Differential Analysis. Retrieved Feb 24, 2018, from https://www.youtube.com/watch?v=fbgNr8THBkM&list=PLbXHiqQHS6rTLZ8_KYE0fB6jY7oio0-UH

Heisinger, K., & Hoyle, J. B.(2012). Accounting for Managers. Creative Commons by-nc-sa 3.0.  

Lumen, Differential Analysis. Retrieved Feb 24, 2018, from https://courses.lumenlearning.com/tcc-managacct/chapter/criteria-used-in-managerial-decision-making/