ACCT-241 Lecture Notes - Lecture 12: Opportunity Cost, Kelley Blue Book, Vehicle Insurance
21 Aug 2018
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CHAPTER 12
Differential Analysis: The Key to Decision Making
Key Concept #1
Every decision involves choosing from among at least two alternatives. Therefore, the first step
in decision making is to define the alternatives being considered. For example, if a company is
deciding whether to make a component part or buy it from an outside supplier, the alternatives
are make or buy the component part. Similarly, if a company is considering discontinuing a
particular product, the alternatives arekeepor dropthe product.
Key Concept #2
Once you have defined the alternatives, you need to identify the criteria for choosing among
them. The key to choosing among alternatives is distinguishing between relevant and irrelevant
costs and benefits. Relevant costs and relevant benefits should be considered when making
decisions. Irrelevant costsand irrelevant benefits should be ignored when making decisions. This
is an important concept for two reasons. First, being able to ignore irrelevant data saves decision
makers tremendous amounts of time and effort. Second, bad decisions can easily result from
erroneously including irrelevant costs and benefits when analyzing alternatives.
Key Concept #3
The key to effective decision making is differential analysis—focusing on the future costs and
benefits that differ between the alternatives. Everything else is irrelevant and should be ignored.
A future cost that differs between any two alternatives is known as a differential cost.
Differential costs are always relevant costs. Future revenue that differs between any two
alternatives is known as differential revenue.Differential revenue is an example of a relevant
benefit.
The terms incremental cost and avoidable cost are often used to describe differential costs. An
incremental cost is an increase in cost between two alternatives. For example, if you are
choosing between buying the standard model or the deluxe model of your favorite automobile,
the costs of the upgrades contained in the deluxe model are incremental costs. An avoidable cost
is a cost that can be eliminated by choosing one alternative over another. For example, assume
that you have decided to watch a movie tonight; however, you are trying to choose between two
alternatives—going to the movie theater or renting a movie.
The cost of the ticket to get into the movie theater is an avoidable cost. You would avoid this
cost by renting a movie. Similarly, the movie rental fee is an avoidable cost because you could
avoid it by going to the movie theater. Avoidable costs (and incremental costs) are always
relevant costs.
Differential costs and benefits can be qualitative or quantitative in nature. While qualitative
differences between alternatives can have an important impact on decisions, and therefore,
should not be ignored; our goal in this chapter is to hone your quantitative analysis skills.
Therefore, our primary focus will be on analyzing quantitative differential costs and benefits—
those that have readily measurable impacts on future cash flows.
Key Concept #4
Sunk costs are always irrelevant when choosing among alternatives. A sunk cost is a cost that has
already been incurred and cannot be changed regardless of what a manager decides to do. Sunk
costs have no impact on future cash flows and they remain the same no matter what alternatives
are being considered; therefore, they are irrelevant and should be ignored when making
decisions.
For example, suppose a company purchased a five-year-old truck for $12,000. The amount paid
for the truck is a sunk cost because it has already been incurred and the transaction cannot be
undone. The $12,000 paid for the truck is irrelevant in making decisions such as whether to keep,
sell, or replace the truck. Furthermore, any accounting depreciation expense related to the truck
is irrelevant in making decisions. This is true because accounting depreciation is a noncash
expense that has no effect on future cash flows. It simply spreads the sunk cost of the truck over
its useful life.1
Key Concept #5
Future costs and benefits that do not differ between alternatives are irrelevant to the decision-
making process. So, continuing with the movie example, assume that you plan to buy a Papa
John’s pizza after watching a movie. If you are going to buy the same pizza regardless of your
movie-watching venue, the cost of the pizza is irrelevant when choosing between the theater and
the rental. The cost of the pizza is not a sunk cost because it has not yet been incurred.
Nonetheless, the cost of the pizza is irrelevant to the choice of venue because it is a future cost
that does not differ between the alternatives.
Key Concept #6
Opportunity costs also need to be considered when making decisions. An opportunity cost is the
potential benefit that is given up when one alternative is selected over another. For
example, if you were considering giving up a high-paying summer job to travel overseas, the
forgone wages would be an opportunity cost of traveling abroad. Opportunity costs are not
usually found in accounting records, but they are a type of differential cost that must be
explicitly considered in every decision a manager makes.
Cynthia is currently a student in an MBA program in Boston and would like to visit a friend in
New York City over the weekend. She is trying to decide whether to drive or take the train.
Because she is on a tight budget, she wants to carefully consider the costs of the two alternatives.
If one alternative is far less expensive than the other, that may be decisive in her choice. By car,
the distance between her apartment in Boston and her friend’s apartment in New York City is
230 miles. Cynthia has compiled the following list of items to consider:
Which costs and benefits are relevant in this decision? Remember, only the differential costs and
benefits are relevant—everything else is irrelevant and can be ignored.
Start at the top of the list with item (a): the original cost of the car is a sunk cost. This cost has
already been incurred and therefore can never differ between alternatives. Consequently, it is
irrelevant and should be ignored. The same is true of the accounting depreciation of $2,800 per
year, which simply spreads the sunk cost across five years.
Document Summary
Every decision involves choosing from among at least two alternatives. Therefore, the first step in decision making is to define the alternatives being considered. For example, if a company is deciding whether to make a component part or buy it from an outside supplier, the alternatives are make or buy the component part. Similarly, if a company is considering discontinuing a particular product, the alternatives arekeepor dropthe product. Once you have defined the alternatives, you need to identify the criteria for choosing among them. The key to choosing among alternatives is distinguishing between relevant and irrelevant costs and benefits. Relevant costs and relevant benefits should be considered when making decisions. Irrelevant costsand irrelevant benefits should be ignored when making decisions. This is an important concept for two reasons. First, being able to ignore irrelevant data saves decision makers tremendous amounts of time and effort. Second, bad decisions can easily result from erroneously including irrelevant costs and benefits when analyzing alternatives.
