Response:
Types of financial information that are considered and disregarded in differential analysis
Differential cost analysis focuses on the increase or decrease in the total expenditure from changes in specific cost aspects resulting from variations in operations. It represents a rise or decline in total costs arising from -
1. Production or distribution of marginally more or less products
2. Modifications in the method of production or delivery
3. The introduction or removal of products
4. Selection of additional sales channels
In differential analysis, changes in revenues, variable costs, and opportunity costs are considered, while fixed costs along with the fixed portion of semi-variable costs are ignored.
Differential analysis is applied to:
1. Dropping or adding a product line
2. Make or buy decisions
3. Continue or cease a product or customer relationship, etc.
Specific revenues and costs should be included when evaluating whether to drop or maintain a:
1. Contribution margin of an unprofitable product should be evaluated
2. Specific fixed costs associated with the unprofitable product need consideration
3. Contributions from other unprofitable products that could be produced with additional capacity should be assessed.
Avoidable fixed costs should be taken into account since these can be eliminated when discontinuing a product or customer. Dividing avoidable fixed costs by the present value ratio will provide the sales threshold below which it's better to cease operations.
Unavoidable fixed expenses are disregarded in evaluations of whether to drop or maintain since these expenses will still occur even if the product or customer is stopped.
shutdown point = avoidable fixed costs/PV ratio
Sunk Costs: Sunk costs refer to expenses that an entity has already incurred and cannot recover. Such costs should not factor into decisions regarding continued investment in ongoing projects, as these expenses cannot be retrieved. Since sunk costs are historical costs incurred prior and are irrelevant for decision-making, for instance, R&D costs and feasibility study costs, etc.
Opportunity Costs: Opportunity costs arise from the failure to utilize resources effectively. These are part of decision-making analysis. Essentially, opportunity cost entails the loss of alternatives when a specific choice is made.
Any loss resulting from selecting one option over another should be weighed while assessing the project.
