Chapter

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Short-Run Alternative

Choice Decisions

26

26-2

Chapter Highlights

• Alternative choice decisions: manager seeks to choose best out of several alternatives

• Introduces construct of differential costs and revenues for several types of problems, each having a relatively short time horizon

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Differential Costs and Revenues

• Costs that are different under one set of conditions than under another

• Revenues that are different under one set of conditions than under another

26-4

Nature of Full and Differential Costs

• Full cost of a product or other cost object = sum of direct cost + fair share of applicable indirect costs

• Differential costs include only those elements of cost that are different under a certain set of conditions

26-5

Source of Data for Full and Differential Costs

• Full costs come from a company’s cost accounting system

• No comparable system for collecting differential costs:– Differential costs are assembled to meet

analytical requirements of a specific problem

26-6

Historical, Full and Differential Costs

• Full cost accounting system collects historical costs

• Differential costs relate to future

• Differential costs show what costs will be if a certain course of action is adopted

26-7

Contribution Analysis

• A tool for analyzing differential costs:– Focuses on contribution margin

• Contribution for a company (or for a product line, division, or other segment of a company) is the difference between its total revenue and its total variable costs

26-8

Alternative Choice Problems

• 2 or more possible alternative courses of action• Manager chooses best alternative• Some choices may be quantified, but this is only

one aspect of analysis and may not be most important factor

26-9

Objective of Alternative Choice Problem

• Seek alternative most likely to achieve objectives of organization

• In a profit oriented business:– Maximizing value of shareholders’ investment by

making alternative choices that earn a satisfactory return on investment

– Return on investment is usually measured using an accounting and not a market-determined measure of return

– Other factors are also likely to influence decision

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Steps in the Analysis

• Define problem• Select possible alternative solutions including

status quo• For each alternative, measure and evaluate

consequences in quantitative terms• Identify consequences that cannot be expressed

in quantitative terms• Evaluate measured quantitative and non-

quantitative consequences• Make decision

26-11

Differential Costs

• Out of pocket costs = avoidable costs = costs that will be different under the proposed alternative than they are in the base case

• No general category of costs can be labeled differential

• Always relates to specific alternatives being analyzed

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Mechanics of Calculation

• No prescribed format; use most convenient

• Cost items unaffected by decisions are not differential and may be disregarded (or treated the same under each alternative)

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Opportunity costs

• Value lost or sacrificed by giving up an alternative course of action

• Not associated with cash outlays• Not measured in accounting records• If an alternative requires resources that would

otherwise be used for income producing purposes, opportunity cost is measured by income that would have been earned had resources been invested otherwise

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Differential Costs

• Differential costs = incremental costs = relevant costs = out-of-pocket costs = avoidable costs

• = variable costs(=marginal costs), if all alternatives involve operating at different volume levels within the relevant range

• May also include fixed costs if any alternative results in changes in step-function costs

• Future costs, which may be best estimated by looking at past/historical costs

• Usually estimates are not precise unless determined by contract

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Sunk Cost

• = a cost that has already been incurred and therefore cannot be changed by any decision currently being considered– e.g. all historical costs

• Not a differential cost• If asset is used it is depreciated, if it is disposed

of it is written off, in either event it is expensed

26-16

Disposal Value

• Relevant and differential cost/revenue if one alternative is to keep equipment and another alternative is disposal

26-17

Types of Alternative Choice Problems

• Problems involving Costs

• Problems involving revenues and costs

• Differential investments

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Problems Involving Costs

• One type of cost is traded for another– Change of method of operation– Make or buy decisions– Economic order quantity decision: trade off

setup costs and inventory carrying costs

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Problems Involving both Revenues and Costs

• Best alternative has most differential income or profit:– Supply and demand analysis– Contribution pricing– Discontinuing a product– Adding a service

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Sensitivity Analysis

• Considers how sensitive quantitative measurements of alternatives are to changes in assumptions

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“Just One” Fallacy

• Each additional unit of production adds just variable costs

• If many units are added step function costs (i.e. fixed costs) are added:– Step-function costs are averaged out over the

additional units of volume

Chapter

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End of Chapter 26

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