Short-term decision-making is largely a process of analyzing the different costs and benefits that would arise from alternative solutions to a particular problem. Relevant revenues or costs in a given situation are future revenues or costs that differ depending on the alternative course of action selected.

This process is often called “differential analysis”. Differential revenue is the difference in revenues between two alternatives. Differential cost or expense is the difference between the amounts of relevant costs for two alternatives.

For certain decisions, revenues do not differ between alternatives. Under those circumstances, management should select the alternative with the least cost. In other situations, costs do not differ between alternatives. Accordingly, management should select the alternative that results in the largest revenue. Many times both future costs and revenues differ between alternatives. In these situations, the management should select the alternative that results in the greatest positive difference between future revenues and expenses (costs).

In our B&B example, we saw the owner make the following assumptions:

One relevant missing cost in this analysis is the investment in the remodeling.

Suppose that in order to convert the room into a guest room with no bath, the cost to remodel is $36,000, but to convert it into a gift shop would be $65,000. How would that change the owner’s decision?

The initial investment is relevant since it is different for each scenario. If it was the same, we could consider it irrelevant to the decision-making process, even though it is highly relevant to the owner in terms of cash outlay, financing, and maybe even non-financial terms such as emotional strain (e.g. worry about whether it will actually pay off).

Let’s take a five-year look at the project, taking the initial investment into account:

What we see in the first column is that after five years, the gift shop is the better option, having brought in a net total of $79,000 taking the initial investment into account. However, in the first four years, the guest room has a higher total ($51,600).

You should be familiar with several terms when talking about costs.

Average cost: The sum of all costs divided by some unit, such as months. For instance, if you pay $60 up-front for three 5-gallon water bottles, and then fill them for $3 each once a month for a year, your total cost will be the initial cost of $60 plus the cost of water for 3 bottles at $3 each for 12 months which is $108. The average monthly cost is ($60 + $108)/12 = $14. Notice that as time progresses, in this case, the average cost goes down as the initial $60 investment is spread over more and more months. In the first month, the average cost was $60 + 9$ = $69. The second month it was $60 + $9 + $9 = $78 divided by two months = $39.

Marginal cost: The cost of the next unit. In our above example, the marginal cost is $9 per month, or, more accurately, $3 per bottle. The cost of filling the next bottle is $3. Marginal cost does not take into account any prior fixed costs. In addition, marginal cost is not necessarily the same as variable costs.

Incremental cost: the cost of expanding output, which like marginal cost, may include fixed and variable costs. Incremental cost may be more closely related to differential cost than it is to margin cost, but you can see that all of the concepts and terms are related.

In differential cost analysis you’ll also hear and use terms like avoidable and unavoidable, direct and indirect (allocated) costs, and sunk and opportunity costs, which we will cover in this module.

For a quick review of these terms, watch:

You can view the transcript for “Managerial Accounting 7.5: Cost Terms Used in Differential Analysis” here (opens in new window).

There are other financial factors we need to take into account, such as the cost of capital (will the owner have to borrow from the bank, and if not, what kind of investment return will the owner lose on the money taken out of savings?) and taxes. There are also non-financial considerations, which we will cover in the next section, but first, check your understanding of the financial information needed for short-term decision-making.