Accounting: The Language of Business - Vol. 1 (Part 147)

I would argue that a majority of the horrors we face would not have happened if the accounting profession developed and enforced better accounting.

Charlie Munger

 Differential Analysis and Product Pricing (Part A)

by

Charles Lamson

Many of the decisions that you make depend on comparing the estimated costs of alternatives. The payoff from such comparisons is described in the following report from a University of Michigan study.

Richard Nevitt and two colleagues quizzed Michigan faculty members and University seniors on such questions as how often they walk out on a bad movie, refuse to finish a bad meal, start over on a week term paper, or abandon a research project that no longer looks promising. They believe that people who cut their losses this way are following sound economic rules: calculating the net benefits of alternative courses of action, writing off past costs that can't be recovered, and weighing the opportunity to use future time and effort more profitably elsewhere.

They find that among faculty members, those who use cost-benefit reasoning in this fashion being more likely to give up on research that isn't getting anywhere or using labor-saving devices as often as possible have higher salaries relative to their age and departments. Not surprisingly, economists are more likely to apply the approach than professors of humanities or biology. Among students, those who have learned to use cost-benefit analysis frequently are apt to have far better grades than their scholastic aptitude test scores would have predicted. Again, the more economics courses the students have the more likely they are to apply cost-benefit analysis outside the classroom.

Dr. Nesbitt concedes that for many Americans, cost-benefit rules often appear to conflict with such traditional principles as "never give up" and "waste not, want not." (Allen L Anton, "Economic Perspective Produces Steady Yields," from People Patterns, The Wall Street Journal, March 31, 1992, P. 81.)

Managers must also consider the effects of alternative decisions on their businesses. In the next several posts, we will discuss differential analysis, which reports the effects of alternative decisions on total revenues and costs. We will also describe and illustrate practical approaches to setting product prices. Finally, we discuss how production bottlenecks influence product mix and pricing decisions.

Differential Analysis

Planning for future operations involves decision making. For some decisions, revenue and cost data from the accounting records may be useful. However, the revenue and cost data for use in evaluating courses of future operations or choosing among competing alternatives are often not available in the accounting records and must be estimated.

Consider the decision by United Airlines to discontinue service to New Zealand (Warren, Reeve, & Fess, 2005). In this decision, the estimated revenues and costs were relevant. The relevant revenues and costs focus on the differences between each alternative. Costs that have been incurred in the past are not relevant to the decision. These costs are called sunk costs.

Differential revenue is the amount of increase or decrease in revenue expected from a course of action as compared with an alternative. To illustrate, assume that certain equipment is being used to manufacture calculators, which are expected to generate revenue of $150,000. If the equipment could be used to make digital clocks, which would generate revenue of $175,000, the differential revenue from making and selling digital clocks is $25,000.

Differential cost is the amount of increase or decrease in cost that is expected from a course of action as compared with an alternative. For example, if an increase in advertising expenditures from $100,000 to $150,000 is being considered, the differential cost of the price is $50,000. 

Differential income or loss is the difference between the differential revenue and the differential cost. Differential income indicates that a particular decision is expected to be profitable, while a differential loss indicates the opposite.

Differential analysis focuses on the effect of alternative courses of action on the relevant revenues and costs. For example, if a manager must decide between two alternatives, differential analysis would involve comparing the differential revenues of the two alternatives with the differential costs.

In the next two posts, we will discuss the use of differential analysis in analyzing the following alternatives:

1. Leasing or selling equipment.

2. Discontinuing an unprofitable segment.

3. Manufacturing or purchasing a needed part.

4. Replacing usable fixed assets.

5. Processing further or selling an intermediate product.

6. Accepting additional business at a special price. 

*WARREN, REEVE, FESS, 2005, ACCOUNTING, 21ST ED., PP. 993-994*

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