|The contribution margin format separates
fixed costs from variable costs; the traditional method does not.
The contribution margin format reports total contribution margin; the
traditional method reports gross margin. In a manufacturing company:
- Contribution margin = Revenue - Variable Manufacturing
Costs - Variable Nonmanufacturing Costs.
- Gross margin = Revenue - Cost of Goods Sold, where cost of
goods sold = variable manufacturing cost of goods sold + fixed
manufacturing cost of goods sold.
|Differential analysis involves analyzing the different costs
and benefits arising from alternative solutions to the situation.
The alternative resulting in the greatest positive difference between
future revenues and future expenses (costs) should be selected when
using differential analysis.
- Relevant costs and revenues are those that differ between
alternatives. Future costs that do not differ between alternatives are
irrelevant and may be ignored since they affect both alternatives
- Differential cost is the amount by which relevant costs
differ between two alternatives. Differential revenue is the amount by
which relevant revenues differ between two alternatives.
- Sunk costs are past costs about which management can do
nothing in the future. These costs are irrelevant to decision making.
- Committed fixed costs relate to the facilities or
organizational structure that a company must have to continue
operations. Discretionary fixed costs are subject to management control
from year to year.
- Opportunity cost is the potential benefit that is foregone
from not following the best alternative course of action.
In establishing short-run prices, the goal is to select that price at
which total future revenues will exceed total future variable costs by
the greatest amount. This choice will result in the greatest total
|Under certain conditions a product may be sold at two or more
different prices in different markets.
- This possibility may enable management to minimize the risk
of loss from having idle personnel and plant capacity.
- Only the differential cost of producing the items needs to
be matched against the differential revenue provided when deciding
whether to accept an offer at lower-than-normal price (average costs
should be ignored).
- If the differential cost is lower than the differential
revenue, the offer should be accepted unless there is an alternative
use for the facilities that would be even more profitable.
- Variable costs set a floor for the selling price.
|Special cost and revenue studies may be called for to assist
management in making decisions concerning adding or dropping given
products, segments, or services to certain customers.
In deciding whether to further process a joint product, the future
revenues and costs should be compared. If the differential
revenue exceeds the differential cost, further processing should take
place before sale. The same analysis is valid in deciding whether
by-products should be discarded or processed further.
- If differential revenue exceeds differential cost (usually
only the difference in future variable costs), the product is making a
contribution to income and should be retained.
- Normally, fixed costs will remain unaffected, and therefore
would not be relevant to the decision.
- If an alternative use of the facilities would produce
future revenues that would exceed future costs by more than the current
use of those facilities, a change to the alternative should be made.
|Differential analysis can also be used in
make-or-buy decisions. [E6-8]
High quality improves the company’s prospects for maintaining or even
increasing its market share in years to come. Quality should be
improved if the differential revenues are greater than the differential
costs given the long-term effect the decision will have on demand.
- The price that would be paid for the part if it were
purchased must be compared with the additional costs that would be
incurred if the part were manufactured (including the opportunity cost
of not using the space and facilities in their best alternative use).
- Other factors such as the competency of existing personnel,
availability of working capital, quality requirements, and borrowing
costs should be considered.