9.1: Introduction to Differential Analysis
Managerial decision making often involves choosing among alternative courses of action. From a financial perspective, the better of two options is either the one that yields the highest amount of income or, if neither produces income, the one that results in the least amount of loss.
Differential analysis is a decision-making technique that examines the benefits and costs associated with each of two options and compares the net results of the two. The alternative selected is the one with the most favorable (or least unfavorable) financial impact. The evaluation includes only those costs that will change if one alternative is selected over another. Fixed costs or other costs that are constant for the two options are excluded from the analysis since they will not differentiate one choice from the other. Sunk costs, which are past expenditures that have already been incurred and cannot be recovered, are also ignored since the amount will be the same regardless of the alternative selected.
A bed & breakfast inn owner uses differential analysis to decide whether to renovate a first-floor guest bedroom or to convert that space to a gift shop. A summary of the year’s revenues and costs for the two alternatives follows.
|
Guest Room |
Gift Shop |
Difference |
|
|
Revenues |
$36,000 |
$42,000 |
|
|
Costs |
(11,000) |
(15,000) |
|
|
Income |
$47,000 |
$57,000 |
$10,000 |
Since the gift shop will yield $2,000 more in operating income than the guest room, the gift shop alternative should be selected.
Seven additional examples will be used to illustrate how differential analysis can be applied to specific business decisions.
- Make or buy a component part
- Continue with or discontinue a business segment
- Lease or sell equipment
- Sell a product or process further
- Keep or replace a fixed asset
- Accept business at reduced price
- Capital investment analysis