Differential analysis decisions, referred to as alternative choices decisions, cover situations with two or more alternative courses of action from which the manager (decision maker) must select the best alternative. A decision involving more than two alternative is called a multiple-alternative choice decision. Some examples of alternative choice decisions are: make or buy, own or lease, retain or replace, repair or renovate, now or later, change versus status quo, slower or faster, export versus local sales, shut down or continue, expand or contract, change the product-mix, take or refuse orders, place special orders, select sale territories, replace present equipment with new machinery, sell at split-up point or process further, etc.
1. Make or Buy/Insourcing Vs Outsourcing Decisions:
Make or buy decisions, also referred to as in-sourcing vs outsourcing decisions, arise when a company with unused production capacity considers the following alternatives:
(a) To buy certain raw materials or subassemblies from outside suppliers.
(b) To use available capacity to produce the items within the company.
The objective of a make or buy decision should be to best utilise the firm’s productive and financial resources. The problem often arises in connection with the possible use of idle equipment, idle space and even idle labour. In such situations, a manager is inclined to consider making certain units instead of buying them in order to utilise existing facilities and to maintain work-force stability. Commitment of new resources may also be involved.
Reasons for Outsourcing:
Outsourcing is purchasing goods and services from outside vendors rather than in sourcing, which is producing the same goods or providing the same services within the organisation.
Organizations often have external opportunities to acquire services or components of products they manufacture rather than providing the service or manufacturing the component internally. The external acquisition of services or components is called outsourcing.
There are three major reasons for outsourcing:
(1) To focus on the key aspects of the business by outsourcing noncore activities,
(2) To improve the quality of support activities, and
(3) To better control costs.
Top 10 motivating factors for organisations to go for outsourcing are :
1. Reduce and control operating costs.
2. Improve company focus.
3. Gain access to world-class capabilities.
4. Free internal resources for other purposes.
5. Obtain resources not available internally.
6. Accelerate reengineering benefits.
7. Eliminate a function difficult to manage/out of control.
8. Make capital funds available.
9. Share risks.
10. Obtain cash infusion.
According to Barfield, Raiborn and Kinney, the following are the factors that should be considered in the outsourcing decision
Relevant Quantitative Factors:
Incremental production costs for each unit
Unit cost of purchasing from outside supplier (price less any discounts available plus shipping, etc.)
Number of available suppliers
Production capacity available to manufacture components
Opportunity costs of using facilities for production rather than for other purposes
Amount of space available for storage
Costs associated with carrying inventory
Increase in throughput generated by buying components
Relevant Qualitative Factors:
Reliability of supply sources
Ability to control quality of inputs purchased from outside
Nature of the work to be subcontracted (such as the importance of the part to the whole)
Impact on customers and markets
Future bargaining position with supplier(s)
Perceptions regarding possible future price changes
A perception about current product prices (are the prices appropriate or, in some cases with international suppliers, is product dumping involved)
For example, assume that a company can make a part that it has been purchasing at a unit cost of Rs 300. The company has been operating at 75% of normal capacities and in the foreseeable future no use for the excess capacity is contemplated except for the possible production of the part. Fixed manufacturing cost amounts to Rs 17,00,000 a year whether the plant operates at 75% or 100% of capacity.
The cost to manufacture 50,000 units of the part that will be needed has been estimated as follows:
Costs that will be incurred under both alternatives are not relevant to the analysis. In the above analysis the fixed manufacturing overhead has not been considered because it has to be incurred under both alternatives. The fixed manufacturing overhead is a sunk cost which is not relevant to the decision. Logically, the costs that will be increased or decreased as a result of making the part should be considered.
Some Other Factors in Make/Buy Decisions:
Make or buy decisions are often complex, involving not only present costs but also projections of future costs resulting from such factors as capacity, trade secrets, technological improvements, product quality, seasonal sales, and production fluctuations. It is responsibility of top management to determine the basic factors that should be taken into account in make or buy decisions.
Another factor to consider in make or buy decisions is the technical ability of the labour that will be utilised in making the product; it should be evaluated against any special training and skills needed. It may also be necessary to acquire specialised plant facilities and equipment to manufacture the new product. The firm should make an analysis of the cost; quality and quantity considerations of the individual make or buy decisions.
Differential cost analysis is especially useful if the company has idle capacity and idle workers that can be used to make the tools or parts. Other potential use of available capacity should also be considered; and qualitative factors must be evaluated in the decision process. These considerations include price stability from suppliers, reliability of delivery and quality of the material or component involved.
In addition, new sources of materials suppliers may be required. To reduce the effect of limitations associated with make or buy decisions, it is necessary that make or buy decisions should always be reviewed by one control entity within the firm. Without this review process, all elements of planning, control and coordination with respect to the firm’s goals are lost, which again is detrimental to the firms long-range survival. The qualitative factors should be evaluated by more than one individual, so personal biases do not cloud valid business judgment.
Horngreen, Datar and Foster observe:
“Outsourcing is not without risks. As a company’s dependence on its suppliers increases, suppliers could increase prices and let quality and delivery performance slip. To minimise these risks, companies generally enter into long-run contracts specifying costs, quality and delivery schedules with their suppliers. Intelligent managers build close partnerships or alliances with a few key suppliers. Toyota goes so far as to send its own engineers to improve suppliers’ processes. Suppliers of companies such as Ford, Hyundai, Panasonic and Sony have researched and developed innovative products, met demands for increased quantities, maintained quality, and on time delivery, and lowered costs — actions that the companies themselves would not have had the competencies to achieve.
Outsourcing decisions invariably have a long-run horizon in which the financial costs and benefits of outsourcing become more uncertain. Almost always, strategic and qualitative factors become important determinants of the outsourcing decision. Weighing all these factors requires the exercise of considerable management judgment and care.”
Similarly, Barefied, Raiborn and Kinney comment:
“Although companies may gain the best knowledge, experience, and methodology available in a process through outsourcing, they also lose some degree of control. Thus, company management should carefully evaluate the activities to be outsourced. Factors to consider include whether (1) a function is considered critical to the organization’s long-term viability (such as product research and development); (2) the organization is pursuing a core competency relative to this function; or (3) issues such as product/service quality, time of delivery, flexibility of use, or reliability of supply cannot be resolved to the company’s satisfaction.”
2. Drop or Add Product Decision:
The decision to eliminate an unprofitable product is a special case of segment or product profitability evaluation. To evaluate the financial consequences of eliminating a product, it is necessary to concentrate on the differential or incremental profit effect of the decision. An important factor in the decision to add or drop a product is whether it will increase or decrease the future income of the business. Appropriate cost and profit measures must be developed for each alternative.
Care must be taken not only to consider the profitability of the product being analyzed but also to evaluate the extent to which sales of other products will be adversely affected when one product is removed. An unprofitable product may be part of a line of products that must be complete in order to attract customers to more profitable products.
The unprofitable product may also be a complement to more profitable products, in which case some customers may buy the more profitable products because the unprofitable product is also available from the same company. If the expected sales decrease of related products is severe enough, it probably would be desirable to retain the product being scrutinized.
Management needs data that will permit development of warning signals for products that may be in trouble.
Such warning signals include:
1. Increasing number of customer complaints.
2. Increasing number of dispatches returned.
3. Declining sales volume.
4. Product sales volume decreasing as a percentage of the firm’s total sales.
5. Decreasing market share.
6. Malfunctioning of the product or introduction of a superior competitive product.
7. Past sales volume not up to projected amounts.
8. Expected future sales and market potential not favourable.
9. Return on investment below a minimum acceptable level.
10. Variable costs approaching or exceeding revenue.
11. Various costs consistently increasing as a percentage of sales.
12. Increasing percentage of executive time required.
13. Price which must be constantly lowered to maintain sales.
14. Promotional budgets which must be consistently increased to maintain sales.
To illustrate the product abandonment decision, assume a company is considering dropping product B from its line because accounting statements show that product B is being sold at a loss.
(i) Factory overhead costs are made up of fixed costs of Rs 5,850 and variable costs of Rs 3,900. Variable costs by products are: product A Rs 3,000. Product B Rs 400, and product C Rs 500.
(ii) Fixed costs and expenses will not be changed if product B is eliminated.
(iii) Variable selling and administrative expenses to the extent of Rs 11,000 can be traced to the product as follows: A, Rs 7,500, B, Rs 1,500: C Rs 2,000.
(iv) Fixed selling and administrative expenses are Rs 10,000.
The decision to drop product B cannot be reasonably made from the above data prepared under a conventional income statement.
This information together with the following statement may be helpful to management:
This statement shows that product B exceeds its variable costs by Rs 2,600. If the sale of product B were discontinued, this marginal contribution would be lost and the net income of the firm would be reduced by Rs 2,600. That is, net income will be Rs 7,150 (Rs 9,750 –Rs 2,600). In this illustration, it has been assumed that sales of products A and C will not be increased after product B is dropped.
Further, it has been assumed that dropping product B will not change the fixed costs and expense. If these assumptions are not true, new analysis must be made. Assume, for example, that after dropping product B, the sales of product A increase by 10%. The total profit of the firm will not increase by this sales increase. Product A makes only a marginal contribution of 34%.
This contribution is less than Rs 2,600 now being realised on the sales of product B. It would take additional sales of product A of approximately Rs 7,647 to equal the marginal contribution of Rs 2,600 now being made by product B:
Marginal contribution of production B/Marginal contribution of product A = 2, 600/34% = Rs 7, 647
It is possible that dropping product B may result in reduction in some of the fixed costs. Product B now contributes Rs 2,600 towards recovery of fixed costs and expenses. Only if the fixed costs and expenses can be reduced by more than this amount it will be advisable to drop product B.
3. Sell or Process Further Decision:
The decision whether a product should be sold at the split-off point or processed further is faced by many manufacturers. The choice between selling a product at split-off or processing it further is short-run operating decision. Additional processing adds value to a product and increases its selling price above the amount for which it could be sold at split-off. The decision to process further depends upon whether the increase in total revenues exceeds the additional costs incurred for processing beyond split-off.
Conditions for Sell or Process Further Decisions:
Generally speaking, there are two general conditions under which a sell or process further decision could occur:
(1) The company is evaluating the possibility of processing beyond split-off and must incur certain equipment costs and other fixed costs if additional processing is to occur.
(2) The company already processes a product beyond split-off and has invested in the equipment and required personnel.
The first situation is really a capital budgeting problem and here it is not sufficient to determine whether incremental revenues exceed incremental costs. Since new investment in machinery and building are involved, the rate of return on this investment must also be considered.
In the second situation, the relevant costs are only those costs which relate to the additional processing of each product beyond the split-off point. The joint costs are relevant to the further processing decisions. Certain fixed costs such as supervisory salaries are related to additional processing. If these costs are eliminated by selling products at split-off, they are incremental and should be included in the decision analysis.
If salaried personnel are assigned other duties in the company when additional processing is discontinued, the salary costs are not incremental since they are incurred under either decision alternative. If the equipment used for additional processing sits idle or can be used in other processes, it should be ignored in the decision analysis. Depreciation expense is never relevant in short-run operating decisions, since depreciation is an allocation of costs incurred in a past time period.
In deciding upon which course of action to follow, the company compares the contribution margin from the sale of the partially processed product with the contribution margin from the sale of the completely processed product. The revenue to be derived from the sale of the partially processed product is the opportunity cost attached to the decision of further processing.
A partially processed product can be sold for Rs 90 per unit which is manufactured at a cost of Rs 60. Further processing can be done at an additional cost of Rs 30 per unit and the final product can be sold at Rs 150 per unit.
The firm can produce 10,000 units. The analysis is shown below:
Net advantage in further processing Rs 6,00,000 – Rs 3,00,000 = Rs 3,00,000 Thus, there is a net advantage of Rs 3,00,000 in processing the product further. The market value of the partially processed product (Rs 9, 00,000) is considered to be the opportunity cost of further processing.
The figure of net advantage of Rs 3, 00,000 can be arrived at in the following manner also:
To take another example, suppose, a firm purchased some material for Rs 1, 00,000 sometime back which would realise Rs 50,000 if sold now. If the material is not sold it could be used in making a product which would sell for Rs 1, 50,000 after incurring additional costs of Rs 65.000.
The analysis is as follows:
It is not always easy to identify all possible opportunities, and it can be even more difficult to impute values to these opportunities. An alternative approach to the above example is to use incremental costing, where the difference between incremental revenues and incremental costs is computed.
The same decision is made, resulting in the manufacture of the product to provide a Rs 35,000 net benefit.
Whitehall Corporation produces chemicals used in the cleaning industry. During the previous month, Whitehall incurred Rs 300,000 of joint costs in producing 60,000 units of AM-12 and 40,000 units of BM- 36. Whitehall uses the units-of-production method to allocate joint costs. Currently, AM-12 is sold at split off for Rs 3.50 per unit. Flank Corporation has approached Whitehall to purchase all of the production of AM-12 after further processing. The further processing will cost Whitehall Rs 90,000.
(i) Concerning AM -12, which one of the following alternatives is most advantageous?
(a) Whitehall should process further and sell to Flank if the total selling price per unit after further processing is greater than Rs 3.00, which covers the joint costs.
(b) Whitehall should continue to sell at split-off unless Flank offers at least Rs 4.50 per unit after further processing, which covers Whitehall’s total costs.
(c) Whitehall should process further and sell to Flank if the total selling price per unit after further processing is greater than Rs 5.00.
(d) Whitehall should process further and sell to Flank if the total selling price per unit after further processing is greater than Rs 5.25, which maintains the same gross profit percentage.
(ii) Assume that Whitehall Corporation agreed to sell AM-12 to Flank Corporation for Rs 5.50 per unit after further processing. During the first month of production, Whitehall sold 50,000 units with 10,000 units remaining in inventory at the end of the month.
With respect to AM-12, which one of the following statements is correct?
(a) The operating profit last month was Rs 50,000, and the inventory value is Rs 15,000.
(b) The operating profit last month was Rs 50,000, and the inventory value is Rs 45,000.
(c) The operating profit last month was Rs 1, 25,000, and the inventory value is Rs 30,000.
(d) The operating profit last month was Rs 2, 00,000, and the inventory value is Rs 30,000.
(i) The correct answer is (C):
The unit price of the product at the split-off point is known to be 3.50, so the joint costs are irrelevant. The additional unit cost of further processing is Rs 1.50 (90,000 60,000 units). Consequently, the unit price must be at least Rs 5.00 (3.50 opportunity cost + 1.50).
Answer (a) is incorrect because the joint costs are irrelevant. Answer (b) is incorrect because the unit price must cover the 3.50 opportunity cost plus the Rs 1.50 of additional costs. Answer (d) is incorrect because any price greater than Rs 5 will provide greater profits, in absolute amount, even though the gross profit percentage declines.
(ii) The correct answer is (b):
Joint costs are allocated based on units of production. Accordingly, the unit joint cost allocated to AM-12 is Rs 3.00 [300,000 – 60,000 units of AM-12 + 40,000 units of BM -36)]. The unit cost of AM-12 is therefore Rs 4.50 [3.00 joint cost + (90,000 additional cost ÷ 60,000 units)]. Total inventory value is Rs 45,000 (10,000 units x 4.50), and total operating profit is 50,000 (5.50 unit price – 4.50), x 50,000 units sold].
Answer (a) is incorrect because the Rs 3 unit joint cost should be included in the inventory value. Answer (C) is incorrect because the Rs 1.50 unit additional cost should be included in total unit cost. Answer (d) is incorrect because the Rs 3 unit joint cost should be included in the cost of goods sold, and inventory should include the Rs 1.50 unit additional cost.
4. Operate or Shutdown Decision:
Differential cost analysis is also used when a business is confronted with the possibility of a temporary shutdown. This type of analysis has to determine whether in the short-run a firm is better off operating than not operating. As long as the products sold recover their variable costs and make a contribution towards the recovery of fixed costs, it may be preferable to operate and not to shutdown. Also management should consider the investment in the training of its employees which would be lost in the event of temporary shutdown.
Recruiting and training new workers would add to present costs. Another factor is the loss of established markets. Also, a temporary shutdown does not eliminate all costs. Depreciation, taxes, interest, and insurance costs are incurred during shutdown also. The other points (benefits) which should be considered are the following: avoiding operating losses, savings in maintenance and repair costs, savings in indirect labour costs, and savings in fixed costs.
Even if sales do not recover the variable cost and the portion of fixed cost that is avoidable, the firm may still be better off operating than shutting down the facility. Closing a facility and subsequently reopening it is a costly process. The shutdown may necessitate the incurrence of maintenance procedures in order to preserve machinery and buildings during periods of inactivity (e.g. rust inhibitors, dust covers, security equipment, etc.).
The shutdown also may require the incurrence of legal expenditures and employee maintenance pay. During the shutdown period, some employees will probably be lost (i.e., they may not wait until the facility is reopened to go back to work), in which case the investment in the training of those employees will be lost. The morale of other employees, as well as company goodwill, may be adversely affected, and the recruiting and training of replacement workers that must be incurred when the facility is later reopened, add to costs.
Although difficult to quantify, the loss of established market share is also a factor to be considered. When a company leaves a market for a while, its customers tend to forget about the company’s product. As a consequence, reentering the market at a latter time will probably require reeducating consumers about the company’s product. These shutdown costs must be weighed against losses from continued operations.
To illustrate an analysis of possible temporary shutdown, assume that a company operating below 50% of its capacity expects that the volume of sales will drop below the present level of 10,000 units per month. Management is concerned that a further drop in sales volume will create a loss and has under consideration a recommendation that operations be suspended, until better market conditions prevail and also a better selling price.
The present operating income statement is as follows:
The following income statements have been prepared for sales at different capacities:
It would appear that shutdown is desirable when the sale volume drops below 6,000 units per month, the point at which operating losses exceed the shutdown cost.
This volume of 6,000 units could be arrived at without an income statement as follows:
If the selling price is cut to Rs 28, the contribution margin will be Rs 8 per unit.
Required sale to recover an additional Rs 60,000 of fixed costs 60,000 /8 = 7, 500 units
That is, sale of 7,500 units would be necessary to recover an additional Rs 60,000 of fixed costs.
5. Special Orders Decision:
All business decisions should not be evaluated in the same way. Sometimes special orders or one time orders have different characteristics from recurring orders. Therefore, each order should be evaluated based on costs relevant to the situation and the goals of the business firm. The question of special orders arises when a company has excess or idle production capacity and management considers the possibility of selling additional products at less than normal selling prices, provided that such a special order will not affect the regular sales of the same product.
The basic problem is to determine an acceptable price for the special order units. Cost analysis using the contribution approach is a useful technique to determine the short-run profit effects of special order transactions. In deciding the pricing of special orders where normal operations are not disturbed and where unused production capacity exists, it is not advisable to attach fixed costs to products.
Price determination should take into account the recovery of incremental (variable) costs caused by accepting the special order. If the normal fixed costs are included in the price of the special order, the price may be too high and the business firm could lose the entire order and the contribution margin to be earned on the special order. Only the relevant (variable) costs should be used in the decision analysis to arrive at an appropriate price. Fixed cost are relevant only if incurred to facilitate the special order.
Importance of Time Span in Special Order:
The special order is a one-time order for specific units, say 1,000 units that will use current excess capacity. Because no special setups or equipment are required to produce the order, it is appropriate to consider only variable costs in computing the order’s profitability.
But what if the order giver wants the company to sign a multiyear contract to provide 1,000 units per month at Rs 925 each? Under these circumstances, management would be well advised to reject the contract because there is a high probability that cost increases would make the order unprofitable in later years. At the very least, management should insist that a cost escalation clause be added to the purchase agreement, specifying that the selling price would increase to cover any cost increases and detailing the cost computation.
Of more concern is the variable nature of all long-run costs. Given adequate time, management must replace fixed assets and may adjust both the number of machines as well as the size of machines used in the manufacturing process. Accordingly, in the long run, all costs (including costs classified as fixed in a given period) are relevant.
To remain in business in the long run, the company must replace equipment, pay property taxes, pay administrative salaries, and so forth. Consequently, management should consider all costs (fixed and variable, manufacturing and nonmanufacturing) in evaluating a long-term contract.
The following example illustrates the special order decisions:
A manufacturing company produces 20,000 units by operating at 60% of the capacity and sells at a price of Rs 3000 per unit.
The budgeted figures for the year 2012 are as follows:
The company receives a special order for 10,000 units from a firm. The company desires to earn a profit of Rs 100 per unit and no selling expenses are to be incurred for the special order.
The minimum price on the special order and income statements are as follows:
From the above analysis it is clear that the acceptance of the special order will increase the profit by Rs 10, 00,000. Also the bid price (Rs 1875) is significantly less than the normal price of Rs 3000.
Although an analysis of cost and revenue information may indicate that a special order would be profitable in the short run, management might still reject the order because of qualitative considerations. Any concerns regarding the order’s impact on regular customers might lead management to reject the order even if there is excess capacity. If the order involves a special low price, regular customers might demand a similar price reduction and threaten to take their business elsewhere.
Alternatively, management might accept the special order while operating at capacity if they believed there were long-term benefits associated with penetrating a new market. Legal factors must also be considered if the special order is from a buyer who competes with regular customers.
6. Replace or Return Decision:
The decision to replace or retain plant and equipment is a capital investment or long-term decision and should be taken very carefully. The differential costs which are important in retain or replace decisions are the following: change in fixed overheads costs, loss on sale of old equipment, capital investment and related costs such as rate of return and interest. Management should also consider differential benefits likely to be derived such as higher production and increased sales, realisable value of old machine, saving in operating costs, tax advantages, if any.
Suppose a company has purchased a plant for Rs 1,00,000 five years ago which has a life of 10 years with no salvage value. The present book value is Rs 50,000. Management is considering the replacement of this plant with a new plant costing Rs 80,000 having a life of five years with no scrap value at the end of its life.
The costs of operating present plant and the proposed plant are as follows:
It appears that the proposed plant would result into cost savings of Rs 24,000 (1,00,000 – 76,000). However, the book value of the present equipment is a sunk cost and not relevant in the decision.
The following analysis helps in making a better use of the data:
The purchase of the new plant results in a saving of Rs 14,000 (Rs 90,000 – 76,000). Management has to consider whether this benefit is enough to justify the investment of Rs 80,000 in new machinery.
To take another example, suppose, the management of a company wants to replace an old machine with a new one.
Data are as follows:
The analysis is as follows:
(a) Disposal value now — represents a future cash inflow.
(b) Cost of new machine — represents a future cash outflow.
(c) Variable costs — incremental costs.
(a) Cost of old machine — past (historical) cost.
(b) Book value and gain or loss on disposal — both involve depreciation and original cost (that is, sunk cost).
(c) Annual revenue — this would be relevant (as it represents a future cash inflow) if it differs between alternatives. But in this example it is common to both options.
On a four-year basis:
Decision again is to replace the old machinery and buy the new machinery.
7. Buy or Lease Decision:
Another problem that management usually faces is whether to buy an asset or whether to lease it. The lease of an asset results into future cash payments (outflow) which should be discounted back to the present. Assume a company is considering whether to lease or buy an asset.
The asset can be purchased for Rs 6,75,00,000 or it may be leased for five years by paying rental payments of Rs 2,50,00,000 per year for the first two years, Rs 1,50,00,000 for the next two years and Rs 1,00,00,000 for the last year. The company can borrow Rs 6,75,00,000 from its bank. If the present value of the five years rental payments exceeds Rs 6,75,00,000 the asset should be purchased and not leased; however, if the present value in aggregate is less than Rs 6,75,00,000 it will be better to lease the asset.
If the lease of the asset is considered an operating lease, the lease payments would be deducted from the revenue annually to arrive at pretax income. This method lowers the tax liability in the earlier years of the asset life than would be allowed if the company were required to depreciate the asset. To determine the benefits in tax liability, it is necessary to consider the interest deductions that would be obtained if a company were to borrow the funds to acquire the asset.
The interest payments would be tax deductible. In addition, the asset would be depreciated and the amount of depreciation would be deducted for income tax purposes. If the asset is to be leased, the total payments would be deducted for income tax purposes. The differences between these two floors must be analysed and the net present value of the difference in tax payments should be determined. This figure will guide management to decide whether to buy or to lease.