Skills to Develop
- Understand cost terms used in differential analysis.
Question: We’ve introduced many new terms in this chapter. What are these important terms, and how do they relate to differential analysis?
The important terms introduced in this chapter are outlined here:
Differential analysis requires that we consider all differential revenues and costs—costs that differ from one alternative to another—when deciding between alternative courses of action. Avoidable costs—costs that can be avoided by selecting a particular course of action—are always differential costs and must be considered when deciding between alternative courses of action.
Opportunity costs—the benefits foregone when one alternative is selected over another—are differential costs, and must be included when performing differential analysis. Sunk costs—costs incurred in the past that cannot be changed by future decisions—are not differential costs because they cannot be changed by future decisions.
Direct fixed costs—fixed costs that can be traced directly to a product line or customer—are differential costs and therefore pertinent to making decisions. However, we must review these costs on a case-by-case basis because some direct fixed costs may not be considered differential in spite of being traced directly to a product line. For example, a five-year lease on a warehouse used solely for one product line is a direct fixed cost but not a differential cost because the costs will continue even if the product line is eliminated.
Allocated fixed costs—fixed costs that cannot be traced directly to a product—are typically not differential costs. For example, if a product line is eliminated, these costs are simply allocated to the remaining product lines.
When deciding between alternatives, only those revenues and costs that differ from one alternative course of action to another are relevant. Avoidable costs, opportunity costs, and direct fixed costs typically fall into this category. Revenues and costs that do not differ from one alternative course of action to another are irrelevant to the decision.
REVIEW PROBLEM 7.5
Match each of the following terms with the appropriate definition in the list given.
- Differential analysis
- Differential revenues and costs
- Avoidable costs
- Sunk costs
- Direct fixed costs
- Allocated fixed costs
- Opportunity costs
- The benefits forgone when one alternative is selected over another.
- Fixed costs that can be traced directly to a product line.
- Revenues and costs that differ from one alternative to another.
- Costs incurred in the past that cannot be changed by future decisions.
- Costs that can be avoided by selecting a particular course of action.
- Fixed costs that cannot be traced directly to a product line.
- Analyzing the difference in revenues and costs from one alternative course of action to another.