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Week_12_Differintial Cost Analysis I

The document discusses differential cost analysis as a crucial tool for managers in decision-making, focusing on costs and benefits that differ between alternatives. It outlines relevant versus irrelevant costs, the make or buy decision, and provides a framework for analyzing these decisions through examples and calculations. The key takeaway is that understanding relevant costs is essential for making informed choices in various business scenarios.

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IQRA NAZ 24735
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14 views

Week_12_Differintial Cost Analysis I

The document discusses differential cost analysis as a crucial tool for managers in decision-making, focusing on costs and benefits that differ between alternatives. It outlines relevant versus irrelevant costs, the make or buy decision, and provides a framework for analyzing these decisions through examples and calculations. The key takeaway is that understanding relevant costs is essential for making informed choices in various business scenarios.

Uploaded by

IQRA NAZ 24735
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Differential Cost Analysis: I

The Key to Decision Making


Week 12
.
• Making decisions is one of the basic functions of a manager.
To be successful in decision making, managers must be
able to perform differential analysis, which focuses on
identifying the costs and benefits that differ between
alternatives.

• The purpose of this chapter is to develop these skills by


illustrating their use in a wide range of decision-making
situations.
• Unit 12.1 Types for Decision making
• Unit 12.2 Relevant Cost and Irrelevant Cost
• Unit 12.3 Application of Relevant and Irrelevant Cost
• Unit 12.4 Make or Buy Decision
• Unit 12.5 Application of Make or Buy Decision
• Unit 12.1 Types for Decision making
Differential Cost
• Differential cost studies deal with the determination of incremental
revenues, cost, and margins with regard to alternative uses of
fixed facilities or available capacity.
• When performing the manufacturing and selling functions,
management is constantly faced with the problem of choosing
between alternative courses of action.
• Typically, questions to be answered include: What to make? How to
make it? Where to sell the product?, and What price should be
charged?
Differential Cost
• Decision making applies, where, we have more than one
choice. In these studies, variable costs are significant,
because, they usually represent the differential cost.
• If however, fixed costs must be increased through the
addition of a new machine or rental of additional space, then
these costs should be considered deferential costs.
In short-run, management is typically faced with the following
nonroutine, nonrecurring types of decisions:
1. Acceptance or rejection of a special order
2. Reducing the price of a product
3. Make or buy a product
4. Sell or process further a product
5. Add or drop a certain product line
6. Utilization of scarce resources
• Unit 12.2 Relevant Cost verses Irrelevant Cost
Relevant information has two characteristics:
1. It occurs in the future
2. It differs among the alternative courses of action.
• Relevant costs are expected future costs.
• Relevant revenues are expected future Revenues.
• Past costs (historical costs) are never relevant and
are also called sunk costs.
.
• Unit 12.3 Application of Relevant and Irrelevant Cost
Steps involves in decision

1. Gather all costs associated with each alternative.


2. Drop the sunk costs
3. Drop those costs which do not change between alternatives
4. Select the best alternative based on the remaining cost data
Relevant / Differential Cost Analysis
Existing Proposed Differential

Sales 100,000
. 125,000 25,000

Less: Variable expenses 80,000 100,000 20,000

Contribution margin 20,000 25,000 5,000

Less: Fixed cost 15,000 15,000 0

Net profit 5,000 10,000 5,000


• Unit 12.4 Make or Buy Decision
• The decision whether to produce a component parts
internally or to buy it externally from an outside supplier is
called a “make or buy” decision.
• This problem arises particularly in connection with the
possible use of idle equipment, idle space, and even idle
labor.
• In such situations, a manager is inclined to consider making
certain parts instead of buying them in order to utilize
existing facilities.
Faced with a make or buy decision, the manager should:
1. Consider the quantity and qualitative factors as well as the
technical know-how required.
2. Compare the cost of making the parts with the cost (price)
of buying them.
3. Compare the making of the parts with possibly more
profitable alternative uses that could be made of the firm’s
own facilities, if the parts are purchased.
• Unit 12.5 Application of Make or Buy Decision
• Make or Buy Decision (Activity)

• Assume that a firm has prepared the following cost estimates for the manufacturing of a subassembly
component based on an annual production of 8,000 units.

Per Unit Total


Direct materials Rs. 5 40,000
Direct labor 4 32,000
Variable FOH 4 32,000
Fixed FOH (applied 150% of direct labor cost) 6 48,000
Total Rs. 19 152,000
The supplier has offered to provide the subsequently at a price of Rs. 16 each.
• Two third of fixed FOH which represents executive salaries, rent, depreciation, and taxes, continue
regardless of the decision.

• Advice: Should the company make or buy the product?


• The key to the decision lies in the investigation of those relevant costs that changes between the make-or-
buy alternatives. Assuming that the production capacity will be idle if not to produce the subassembly.
• The analysis takes the following from:

Per Unit Total 8,000 Units


Make Buy Make Buy
Purchase price Rs. 16 128,000
Direct materials Rs. 5 40,000
Direct labor 4 32,000
Variable FOH 4 32,000
Fixed FOH that can be avoided by not making 2 16,000
Total Rs. 15 16 120,000 128,000

Diff erence in favor of making (16-15) Rs. 1 8,000

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