Differential Analysis

Differential Costs

Differential Approach to Decision-Making

Differential analysis focuses only on relevant costs.

When companies use differential analysis to help them make decisions, they focus only on the relevant costs of the various alternatives. Relevant costs are those that differ among the alternatives. Limiting analysis this way helps keep irrelevant information from becoming part of the decision-making process and inadvertently leading to a poor decision.

For example, a company that produces widgets on an assembly line may consider renting an enhanced machine. This widget-making machine would allow managers to eliminate 10 workers from the assembly line. These workers have been making widgets by hand. The wages and benefits of the 10 assembly-line workers are relevant costs to the decision-making process, as those would be eliminated with the rental of the machine. However, the overhead the company pays for the building where the assembly line is located is an irrelevant cost in this case. That cost will be the same whether the business rents the machine or not.

Renting the widget-making machine also increases relevant costs associated with the rental price of the machine plus taxes, delivery, setup, and so on. There may also be expenses associated with operating, insuring, and maintaining the machine. The company may need to hire employees who know how to operate and maintain the machine. Those expenses would reduce the comparative wage savings of eliminating 10 assembly-line jobs.

Finally, the widget-making machine will run for only a certain number of years. After that, the company will need to decide whether to rent a new one or again hire assembly-line workers.

The differential analysis approach to decision-making focuses on variables related only to relevant costs. It excludes all irrelevant cost data from the decision-making process.

Total Costs versus Differential Costs

Some costs are not relevant to the decision being made.

The differential approach of decision analysis focuses solely on analyzing the relevant costs and benefits of the various alternatives. This is in contrast to the total cost approach to decision-making, which involves consideration of all of the costs and benefits, relevant or not, to the decision-making process. When performed correctly, the two methods should provide the same answer.

In the example of a company that is deciding whether to lease a new widget-making machine, many inputs will remain the same: the number of units sold and produced, the selling price of the units, the costs of materials to produce the widgets, and fixed expenses such as the overhead of the factory where the widgets are produced. The primary differences between leasing a widget-making machine and continuing to have people make the widgets by hand will involve differences in labor costs and differences in the rental expense and upkeep associated with the machine.

A manager using the differential cost approach would compare the cost of renting the new machine (which would be $5,000 monthly) to labor savings (which would be $15,000 monthly). The manager would conclude that the company should rent the machine, as there would be a net improvement to the bottom line of $15,000$5,000=$10,000\$\rm{15{,}000}-\$\rm{5}{,}{000}=\$\rm{10}{,}{000} per month.

Sample Analysis Showing Differential and Total Costs

This example shows the process many companies go through when looking at differential and total costs. Renting a machine would cost $5,000 per month in fixed expenses but would save $15,000 per month in variable expenses.
A total cost approach would account for figures that do not change either way, such as the direct materials expense, fixed overhead for the factory, and selling price of the widgets produced. Therefore, the same decision is reached regardless of which method of analysis the manager uses. However, using the differential approach of only considering relevant costs involves fewer calculations.

Total Cost Approach

The total cost approach includes factors that do not change the costs associated with each possible decision. Although this approach is more thorough, it takes more time and increases the chance of error.
Using relevant costs when possible makes the most sense for a business that is applying differential analysis. The managers are more likely to have on hand, or be able to easily obtain, the information needed to compare relevant costs across the alternative choices. Making considerations based on the total costs would require a full income statement's worth of information for every alternative. Also, focusing on just the relevant data helps to hone the decision-making process and makes sure managers are not considering irrelevant information that may lead to poor decision-making.