Decision-Making Using Differential Analysis

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.