- Explain the process of differential analysis
Remember back to Module 11: Relevant Revenues and Costs where we discussed relevant and irrelevant costs and defined differential costs. We went into some discussion of differential analysis, but let’s take a closer look.
Differential cost is defined as the difference in cost between any two alternative choices, so differential analysis will look at all possible scenarios to make a decision!
Differential analysis involves looking at all possible scenarios of a decision, but ignoring some costs that are not relevant to the decision itself. We started talking in Module 11: Relevant Revenues and Costs, about costs that should not play in to the choices we need to make. We, as managers, simply need to focus on the costs and revenues that differ between the two choices.
So, reviewing some key terms in the process is important:
- Differential cost (relevant cost): the difference in cost between two choices.
- Differential revenue (relevant benefits): the difference in revenue between two choices
- Sunk cost: a cost that has already been incurred, so won’t be avoided no matter what decision is made.
- Avoidable cost: a cost that CAN be eliminated depending on the decision made.
- Opportunity cost: the potential benefit that is given up if an alternative decision is made.
So we need to ignore those things that remain constant, regardless of the decision we make. An example could be the rent paid on the building. It won’t matter whether you are making widget A, B or C, you still have to pay for the building, right? So rent would not be relevant to the decision regarding which product to make or sell.
As managers, we need to look at all of the costs, and then determine which ones matter for the decision we are making. The relevant costs can differ for different decisions, so it is important to look at all of the costs involved, and look at each one independently for each decision!
We will look at a variety of decisions in this module to help you practice your differential analysis skills!