Principal Concepts of Decision-Making
Most companies have a tremendous number of options in terms of which products or services to provide, how to create them, and who to hire and fire. Many owners and managers use differential analysis to help them sift through the options and make informed decisions. Differential analysis is a systematic way of examining the costs and benefits of the various decisions that a company could make.
Six important concepts guide companies as they use differential analysis.
The first is that every decision must involve choosing from two or more alternatives. For example, if a company is producing a new product, managers have to determine if the company should make the component parts or buy them from a supplier. There may even be other alternatives, such as of doing some of each, but there need to be at least two alternatives for every decision.
The second key concept is that once the alternative choices have been identified, decision makers must develop criteria for choosing among them. Decision makers focus on determining the relevant costs and relevant benefits of each choice, while ignoring irrelevant factors. A relevant cost is an expense that a company should consider to be important when making a decision. For instance, a new product may cost so much to manufacture that its makers decide to save money by using cheaper materials in its other, older products. A relevant benefit is an advantage a company should consider to be important when making a decision using differential analysis. For example, will offering a new service bring in new customers?
The third key concept is that it is important to account for differential cost and differential revenue. When a company considers differential cost, it calculates the future expense of a decision and the future expense of one or more alternatives to that decision. When a company considers differential revenue, it calculates the future sales that would result from a decision and the future sales of one or more alternatives. Considering these two factors allows managers to compare costs and revenues the company would receive from each alternative choice.
Companies also look at avoidable cost and incremental cost as part of accounting for differential cost and differential revenue. An avoidable cost is an expense a manager eliminates by choosing one alternative over another in a decision-making process. An incremental cost is an increase in an expense that happens when choosing between two or more alternatives. For example, if someone is choosing between going out to eat for dinner or eating at home, each choice has avoidable costs. To go out to eat, the person incurs the incremental costs of the restaurant bill, but they avoid the cost of buying food to prepare at home. If the person chooses to eat at home, then the incremental and avoidance costs are reversed for choosing to forgo the restaurant expense.
The fourth decision-making concept is that a company should be sure to account for all sunk costs. A sunk cost is a cost that has already been incurred and is irreversible, regardless of a final decision. For example, if a company obtains a permanent license to produce a certain product and then later decides to stop producing that product and instead produce a different item, the license used to produce the first product is a sunk cost. That money has been spent and cannot be recovered, whether the company chooses to continue to use the license to produce the original product or not.
The fifth decision-making concept is to avoid irrelevant costs. These are considerations of future costs that will not change based on other alternatives. For example, if an individual is going to buy ice cream from a local store for dessert regardless of where they eat dinner, the cost of the ice cream is not relevant to the decision-making process of where to eat dinner. The cost will be the same for the ice cream regardless of where the person eats dinner.Finally, the sixth decision concept is that a company should pay attention to opportunity cost. An opportunity cost is a potential benefit a company gives up when it selects one alternative in place of another. To make an informed decision, business leaders calculate the cost of potential benefits lost when they choose one alternative over another. For example, if a farmer chooses to plant corn in her fields, the opportunity cost is any other crop she may have planted in those same fields instead, such as wheat or soybeans.
Differential Analysis Decision-Making Process
Defining and Identifying Relevant Costs
For a company to properly apply the six principles of decision-making when engaging in differential analysis, managers must ensure that they are considering only relevant and important information, especially in relation to relevant costs.
Consider a small-business owner who is deciding how to travel to a regional trade show. At the trade show, she will present the company's product, make sales, and network. When she is deciding how to travel to the conference, there are many costs, some of which are relevant and some of which are not.
For example, one choice may be flying, which would include the price of a round-trip plane ticket. The other would be driving her own vehicle, which would include gasoline costs, wear and tear on the vehicle, tolls, and parking fees. Other alternatives may include traveling by train or renting a vehicle for the drive.
The owner would not want to consider irrelevant costs such as the entrance fee for attending the trade show, the hotel expense, and money spent on food. These items will cost the same regardless of the means of travel. The owner also would not want to consider vehicle costs, such as the monthly amount paid to lease a personal vehicle or the annual costs of auto insurance, maintaining a valid driver's license, and maintaining a valid license plate and registration.
If there are any differences in what expenses could be written off against taxes compared to the various travel alternatives, the small-business owner would want to account for those as well.
It is also important to remember that in business situations, not all priorities are quantifiable in dollars. There can be qualitative factors as well as quantitative factors that drive decision-making. For example, the small-business owner making a decision about traveling to a regional trade show may also want to assign a positive or negative qualitative value to certain factors, such as the benefit of being able to relax and work on a plane or train while traveling, compared to the hassle of driving in traffic and finding parking at the destination. She might also consider the benefit of having a car available at the trade show versus having to rely on other (possibly expensive) ways to get around while at the trade show. Not all decisions can be made solely by considering quantitative data points. In some situations, quality of life and other factors not driven by data are as important or more important in the decision-making process.
Once the owner has fully considered all the feasible options, she will be in a better position to make an informed decision.